2015-Essay 27 Question PDF

CMA EXAM
Essay Questions
For Practice
Parts 1 and 2
© Copyright 2014 Institute of Certified Management Accountants

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Introduction
The Institute of Certified Management Accountants (ICMA) is publishing this book of practice
questions with answers to help you prepare for the CMA examination. These questions are actual
“retired” questions from the CMA exams and are intended to supplement other study materials.
These practice questions will help you test your understanding of the concepts and rules included in
your CMA study materials by requiring you to apply those concepts and rules to unique and varying
situations. You will encounter different scenarios and applications on your actual examination so it
is essential that you understand the underlying concepts. In general, it will not be helpful to you to
memorize particular questions.
Essay questions appear in both Part 1 and Part 2 of the CMA exam and combine topics from the part
in which they appear. No inference should be made from the lack of practice questions in any topic
areas.
The CMA Program is a rigorous test of your skills and capabilities and requires dedication to be
successful. We hope that these practice questions will be a valuable resource as you pursue your goal
of certification. Good luck!

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CMA Part 1 Essay Practice Questions
(Answers begin on Page 61)
Question 1.1 – Coe Company
Coe Company is a manufacturer of semi-custom motorcycles. The company used 500 labor hours to
produce a prototype of a new motorcycle for one of its key customers. The customer then ordered
three additional motorcycles to be produced over the next six months. Coe estimates that the
manufacturing process for these additional motorcycles is subject to a 90% learning curve. Although
the production manager was aware of the learning curve projections, he decided to ignore the
learning curve when compiling his budget in order to provide a cushion to prevent exceeding the
budgeted amount for labor.
REQUIRED:
1. By using the cumulative average-time learning curve, estimate the total number of labor hours
that are required to manufacture the first four units of product. Show your calculations.
2. Assume the 90% learning curve is realized. Calculate Coe’s cost savings in producing the three
additional units if the cost of direct labor is $25 per hour. Show your calculations.
3. a. Define budgetary slack.

b. Identify and explain two negative effects that budgetary slack can have on the budgeting
process.
4. Assume that Coe actually used 1,740 labor hours to produce the four units at a total cost of
$44,805.
a. If the company ignored the learning curve when creating the budget, for the four units
produced, compute Coe’s
1. direct labor rate (price) variance.
2. direct labor efficiency variance.
b. How would the above two variances differ if the learning curve had been considered when
creating the budget? Show your calculations.
5. Assume that the price variance is unfavorable and the efficiency variance is favorable. Identify
and discuss one reason that explains both of these variances.
6. Explain the effect on the direct labor efficiency variance if the manufacturing process were
subject to an 80% learning curve.
7. Identify and explain one limitation of learning curve analysis.

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Question 1.2 – Law Services Inc.
Law Services Inc. provides a variety of legal services to its clients. The firm’s attorneys each have
the authority to negotiate billing rates with their clients. Law Services wants to manage its operations
more effectively, and established a budget at the beginning of last year. The budget included total
hours billed, amount billed per hour, and variable expense per hour. Unfortunately, the firm failed to
meet its budgeted goals for last year. The results are shown below.
Actual Budget
Total hours billed 5,700 6,000
Amount billed/hour $275 $325
The budgeted variable expense per hour is $50, and the actual total variable expense was $285,000.
There is disagreement among the attorneys over the reasons that the firm failed to meet its budgeted
goals.
REQUIRED:
1. What is the advantage of using a flexible budget to evaluate Law Services’ results for last year as
opposed to a static budget? Explain your answer.
2. Explain the process of creating a flexible budget for Law Services.
3. Calculate the total static budget revenue variance, the flexible budget revenue variance, and the
sales-volume revenue variance. Show your calculations.
4. a. Calculate the variable expense variance. Show your calculations.

b. Was the variable expense variance a flexible budget variance or a sales volume variance?
Explain your answer.

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Question 1.3 – Inman Inc.
Inman Inc. is a manufacturer of a single product and is starting to develop a budget for the coming
year. Because cost of goods manufactured is the biggest item, Inman’s senior management is
reviewing how costs are calculated. In addition, senior management wants to develop a budgeting
system that motivates managers and other workers to work toward the corporate goals. Inman has
incurred the following costs to make 100,000 units during the month of September.
Materials $400,000
Direct labor 100,000
Variable manufacturing overhead 20,000
Variable selling and administrative costs 80,000
Fixed manufacturing overhead 200,000
Fixed selling and administrative costs 300,000
Inman Inc.’s September 1 inventory consisted of 10,000 units valued at $72,000 using absorption
costing. Total fixed costs and variable costs per unit have not changed during the past few months.
In September, Inman sold 106,000 units at $12 per unit.
REQUIRED:
1. Using absorption costing, calculate the following.

a. Inman’s September manufacturing cost per unit
b. Inman’s September 30 inventory value
c. Inman’s September net income
2. Using variable costing, calculate the following.

a. Inman’s September manufacturing cost per unit
b. Inman’s September 30 inventory value
c. Inman’s September net income
3. Identify and explain one reason why the income calculated in the previous two questions might
differ.
4. Identify and discuss one advantage of using each of the following:

a. absorption costing
b. variable costing
5. a. Identify one strength and one weakness each of authoritative budgeting and participative
budgeting.
b. Which of these budgeting methods will work best for Inman Inc.? Explain your answer.
c. Identify and explain one method the top managers can take to restrict the Production
Manager from taking advantage of budgetary slack.

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Question 1.4 – Smart Electronics:
Smart Electronics manufactures two types of gaming consoles, Models M-11 and R-24. Currently,
the company allocates overhead costs based on direct labor hours; the total overhead cost for the past
year was €80,000. Additional cost information for the past year is presented below.
Total Direct
Labor Hours Direct Costs Selling Price
Product Name Used Units Sold per Unit per Unit
M-11 650 1,300 €10 €90
R-24 150 1,500 €30 €60
Recently, the company lost bids on a contract to sell Model M-11 to a local wholesaler and was
informed that a competitor offered a much lower price. Smart’s controller believes that the cost
reports do not accurately reflect the actual manufacturing costs and product profitability for these
gaming consoles. He also believes that there is enough variation in the production process for
Models M-11 and R-24 to warrant a better cost allocation system. Given the nature of the electronic
gaming market, setting competitive prices is extremely crucial. The controller has decided to try
activity-based costing and has gathered the following information.
Number of Number of Material

Number of Setups Components Movements
M-11 3 17 15
R-24 7 33 35
Total activity cost €20,000 €50,000 €10,000
The number of setups, number of components, and number of material movements ghave been
identified as activity-cost drivers for overhead.
REQUIRED:
1. Using Smart’s current costing system, calculate the gross margin per unit for Model M-11 and
for Model R-24. Assume no beginning or ending inventory. Show your calculations.
2. Using activity-based costing, calculate the gross margin for Model M-11 and for Model R-24.
Assume no beginning or ending inventory. Show your calculations.
3. Describe how Smart Electronics can use the activity-based costing information to formulate a
more competitive pricing strategy. Be sure to include specific examples to justify the
recommended strategy.
4. Identify and explain two advantages and two limitations of activity-based costing.

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Question 1.5 – Ace Contractors
Ace Contractors is a large regional general contractor. As the company grew, Eddie Li was hired as
the controller and tasked with analyzing the monthly income statements and reconciling all of the
accounts formerly handled by Susan Zhao, the sole accounting associate. Li noticed a large amount
of demolition expense for February, even though no new projects had started over the past few
months. Since Li did not expect such a large amount of demolition expense, nor was any of this type
of expense budgeted, Li dug a little deeper. He found that all of those expenses were bank transfers
into another bank account. After additional research, it became evident that Zhao had been
transferring funds out of the company bank account and into her own, and recording fake expenses
to make the bank account reconciliation work. While the president kept the prenumbered checks
locked up until check run time and signed all of the outgoing checks, he was unaware of the ability
to initiate transfers via the internet. Li had also reviewed the bank reconciliations, which were
completed by the office manager, and this fraud was not evident since the ending balance was
reasonable.
REQUIRED:
1. a. Identify and explain the four types of functional responsibilities that should be segregated
properly.
b. Identify and explain two incompatible duties that Zhao had that allowed her to take company
funds.
2. Identify and explain two ways that the company had attempted to safeguard its assets and
suggest two ways to strengthen controls in this area.
3. Refer to COSO’s Internal Control Framework to answer the following questions.

a. Identify and describe the three objectives of internal control.
b. Identify and describe five components of internal controls.
4. Identify and explain three ways internal controls provide reasonable assurance.

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Question 1.6 - SmallParts
SmallParts is a manufacturer of metal washers, screws, and other parts required in the manufacture
of various handmade craft and novelty items. The firm has the ability to custom make virtually any
small part, provided the client is able to provide SmallParts with the dimensions and tolerance
required of the product. Because of its niche in the market, SmallParts has over 1,000 clients.
Unfortunately, many of its small business clients eventually merge or cease operations. One of the
company’s biggest challenges is the return of shipped product. Usually, this is because the small
business client has ceased operations. While most of the product is custom made, SmallParts has
found that much of it can be sold to other clients for adapted use. The company’s accountant is
reviewing the company’s internal controls and financial accounting procedures, in particular, with
respect to inventory.
Currently, SmallParts has one salesperson responsible for marketing returned product. This
salesperson has exclusive and total control over the returned product including arranging of sales
terms, billing, and collection. The salesperson receives the returned product and attempts to find a
client who may be able to adapt the product for the client’s use. The inventory of returned product is
not entered in the accounting records, under the logic that the cost is sunk. Revenue generated from
its sale is classified as other revenue on the SmallParts income statement.
REQUIRED:
1. Identify and describe the three objectives of a system of internal control.
2. Identify and explain three ways that the procedure for handling returned product violates the
internal control system of segregation of duties.
3. Identify four functional responsibilities within an organization that should be separated. Explain
why these responsibilities should be separated.
4. Identify and describe three ways that SmallParts can provide for better internal control over its
inventory of returned product.

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Question: 1.7 – Michael Hanson
Michael Hanson is an internal auditor who has been asked to evaluate the internal controls and risks
of his company, Consolidated Enterprises Inc. He has been asked to present recommendations to
senior management with respect to Consolidated’s general operations with particular attention to the
company’s database procedures. With regard to database procedures, he was specifically directed to
focus attention on (1) transaction processing, (2) virus protection, (3) backup controls, and (4)
disaster recovery controls.
REQUIRED:
1. Define the objectives of

a. a compliance audit.
b. an operational audit.
2. For each of the areas shown below, identify two controls that Hanson should review and explain
why.
a. Transaction processing.
b. Virus protection.
c. Backup controls.
3. Identify four components of a sound disaster recovery plan.
4. During his evaluation of general operations, Hanson found the following conditions.
a. Daily bank deposits do not always correspond with cash receipts.
b. Physical inventory counts sometimes differ from perpetual inventory records, and there have
been alterations to physical counts and perpetual records.
c. An unexplained and unexpected decrease in gross profit percentage has occurred.
For each of these conditions, (1) describe a possible cause of the condition and (2) recommend
actions to be taken and/or controls to be implemented that would correct the condition.

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Question 1.8 – Brawn Technology
Brawn Technology, Inc. is a manufacturer of large wind energy systems. The company has its
corporate headquarters in Buenos Aires and a central manufacturing facility about 200 miles away.
Since the manufacturing facility is so remote, it does not receive the attention or the support from the
staff that the other units do. The president of Brawn is concerned about whether proper permits have
been issued for new construction work being done to handle industrial waste at the facility. In
addition, he wants to be sure that all occupational safety laws and environmental issues are being
properly addressed. He has asked the company’s internal auditor to conduct an audit focusing on
these areas of concern.
REQUIRED:
1. Identify and describe the two fundamental types of internal audits. Using examples, describe two
situations where each type of audit would be applicable.
2. Referring to Brawn Technology,

a. identify the type of audit that would best address the concerns of the president .
b. identify the objective of this audit.
c. give two reasons why this type of audit would best address the concerns of the president.
3. Recommend two procedures that could be implemented at Brawn’s manufacturing plant that
would lessen the president’s concerns. Explain each of your recommendations.

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Question 1.9 - Thompson
Klein, Thompson’s CFO, has determined that the Motor Division has purchased switches for its
motors from an outside supplier during the current year rather than buying them from the Switch
Division. The Switch Division is operating at full capacity and demanded that the Motor division
pay the price charged to outside customers rather than the actual full manufacturing costs as it has
done in the past. The Motor Division refused to meet the price demanded by the Switch Division.
The Switch Division contracted with an outside customer to sell its remaining switches and the
Motor division was forced to purchase the switches from an outside supplier at an even higher price.
Klein is reviewing Thompson’s transfer pricing policy because she believes that sub-optimization
has occurred. While Klein believes the Switch Division made the correct decision to maximize its
divisional profit by not transferring the switches at actual full manufacturing cost, this decision was
not necessarily in the best interest of Thompson.
Klein has requested that the corporate Accounting Department study alternative transfer pricing
methods that would promote overall goal congruence, motivate divisional management performance,
and optimize overall company performance. The three transfer pricing methods being considered
are listed below. One of these methods will be selected, and will be applied uniformly across all
divisions.
 Standard full manufacturing costs plus markup.
 Market selling price of the products being transferred.
 Outlay (out-of-pocket) costs incurred to the point of transfer plus opportunity cost per unit.
REQUIRED:
1. Identify and explain two positive and two negative behavioral implications that can arise from
employing a negotiated transfer price system for goods that are exchanged between divisions.
2. Identify and explain two behavioral problems that can arise from using actual full (absorption)
manufacturing costs as a transfer price.
3. Identify and explain two behavioral problems most likely to arise if Thompson Corporation
changes from its current transfer pricing policy to a revised transfer pricing policy that it applies
uniformly to all divisions.
4. Discuss the likely behavior of both “buying” and “selling” divisional managers for each of the
following transfer pricing methods being considered by Thompson Corporation.
a. Standard full manufacturing costs plus markup.
b. Market selling price of the products being transferred
c. Outlay (out-of-pocket) costs incurred to the point of transfer plus opportunity cost per unit.

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Question 1.10 – Biscayne Industries
Biscayne Industries manufactures tents in a variety of sizes by using a variety of materials. Last
year’s income statement data is shown below.
Sales (100,000 units sold) $50,000,000

Cost of goods sold (2/3 fixed) 30,000,000
Gross profit 20,000,000
Selling and administrative costs (all fixed) 12,000,000
Operating income $ 8,000,000
Biscayne did not foresee any changes for this year, so it created a master budget that was the same as
last year’s actual results. At the end of this year, however, Biscayne’s sales totaled $55,000,000.
There were no variable cost variances, and the company’s operating income was $7,500,000.
REQUIRED:
1. Identify and explain three benefits of using a flexible budget.
2. Prepare Biscayne’s flexible budget through operating income, at the $55,000,000 sales level.
3. Identify and explain three possible reasons Biscayne’s sales increased, but the company’s
operating income decreased.
4. Define zero-based budgeting.

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Question 1.11 – Brown Printing
Brown Printing, a small family-owned business, began operations on March 1, manufacturing

premium quality books. The owners have expertise in printing but no accounting knowledge or
experience. The company’s independent accountant compiled the following data for the month of
March. They have also requested an income statement.
Sales price $90 per book

Number of units produced 15,000 books
Number of units sold 10,000 books
Direct materials cost $15 per book
Direct labor cost $6 per book
Variable manufacturing overhead $4 per book
Fixed manufacturing overhead $240,000 per month
Selling cost 3 per book
Administrative expenses $160,000 per month
The owners want to understand these numbers and how they can use the information to run the
business.
REQUIRED:
1. Define and explain absorption costing and variable costing.
2. a. Calculate the unit cost of goods sold using variable costing.

b. Prepare the income statement for March using variable costing.
3. a. Calculate the unit cost of goods sold using absorption costing.

b. Prepare the income statement for March using absorption costing.
4. a. Identify and describe two advantages of using variable costing.

b. Identify and describe two limitations of using absorption costing.
5. Explain why there is a difference in net income between variable costing and absorption
costing. Show your calculations.
6. Define and explain throughput costing.

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Question 1.12 - TruJeans
TruJeans, a new startup company, plans to produce blue jean pants, customized with the buyer's first
name stitched across the back pocket. The product will be marketed exclusively via an internet
website. For the coming year, sales have been projected at three different levels: optimistic, neutral,
and pessimistic. TruJeans does keep inventory on hand, but prefers to minimize this investment.
The controller is preparing to assemble the budget for the coming year, and is unsure about a number
of issues, including the following.
 The level of sales to enter into the budget.

 How to allocate the significant fixed costs to individual units.
 Whether to use job order costing or process costing.
In addition, the controller has heard of kaizen budgeting and is wondering if such an approach could
be used by TruJeans.
REQUIRED:
1. How can the controller use the expected value approach to set the sales level for the budget?
What additional information would be needed?
2. How could the use of variable (direct) costing mitigate the problem of how to allocate the fixed
costs to individual units?
3. Which cost system seems to make more sense for TruJeans, job order costing or process costing?

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Question 1.13 – Sonimad Sawmill
Sonimad Sawmill Inc. (SSI) purchases logs from independent timber contractors and processes the
logs into the following three types of lumber products.
 Studs for residential building (e.g., walls, ceilings).

 Decorative pieces (e.g., fireplace mantels, beams for cathedral ceilings).
 Posts used as support braces (e.g., mine support braces, braces for exterior fences around
ranch properties).
These products are the result of a joint sawmill process that involves removal of bark from the logs,
cutting the logs into a workable size (ranging from 8 to 16 feet in length), and then cutting the
individual products from the logs, depending upon the type of wood (pine, oak, walnut, or maple)
and the size (diameter) of the log. The joint process results in the following costs and output of
products for a typical month.
Joint production costs:

Materials (rough timber logs) $ 500,000
Debarking (labor and overhead) 50,000
Sizing (labor and overhead) 200,000
Product cutting (labor and overhead) 250,000
Total joint costs $1,000,000
Product yield and average sales value on a per unit basis from the joint process are as follows.
Product Monthly Output Fully Processed Sales Price
Studs 75,000 $ 8
Decorative pieces 5,000 100
Posts 20,000 20
The studs are sold as rough-cut lumber after emerging from the sawmill operation without further
processing by SSI. Also, the posts require no further processing. The decorative pieces must be
planed and further sized after emerging from the SSI sawmill. This additional processing costs SSI
$100,000 per month and normally results in a loss of 10% of the units entering the process. Without
this planning and sizing process, there is still an active intermediate market for the unfinished
decorative pieces where the sales price averages $60 per unit.
REQUIRED:
1. Based on the information given for Sonimad Sawmill Inc., allocate the joint processing costs of
$1,000,000 to each of the three product lines using the
a. relative sales value method at split-off.
b. physical output (volume) method at split-off.
c. estimated net realizable value method.
2. Prepare an analysis for Sonimad Sawmill Inc. to compare processing the decorative pieces
further as they presently do, with selling the rough-cut product immediately at split-off and
recommend which action the company should take. Be sure to provide all calculations.

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Question 1.14 – Lawton Industries
For many years, Lawton Industries has manufactured prefabricated houses where the houses are
constructed in sections to be assembled on customers’ lots. The company expanded into the pre-cut
housing market in 2006 when it acquired Presser Company, one of its suppliers. In this market, various
types of lumber are pre-cut into the appropriate lengths, banded into packages, and shipped to
customers’ lots for assembly. Lawton decided to maintain Presser’s separate identity and, thus,
established the Presser Division as an investment center of Lawton.
Lawton uses return on average investment (ROI) as a performance measure the investment defined as
operating assets employed. Management bonuses are based in part on ROI. All investments in
operating assets are expected to earn a minimum return of 15% before income taxes. Presser’s ROI has
ranged from 19.3% to 22.1% since it was acquired in 2006. The division had an investment opportunity
in the year just ended that had an estimated ROI of 18% but Presser’s management decided against the
investment because it believed the investment would decrease the division’s overall ROI.
Presser’s operating statement for the year just ended is presented below. The division’s operating assets
employed were $12,600,000 at the end of the year, a 5% increase over the balance at the end of the
previous year.
Presser Division Operating Statement

For the Year Ended December 31
($000 omitted)
Sales revenue $24,000

Cost of goods sold 15,800
Gross profit $ 8,200
Operating expenses
Administrative $2,140
Selling 3,600 5,740
Income from operations
before income taxes $ 2,460
REQUIRED:
1. Calculate the following performance measures for the year just ended for the Presser Division of
Lawton Industries.
a. Return on average investment in operating assets employed (ROI).
b. Residual income calculated on the basis of average operating assets employed.
2. Would the management of Presser Division have been more likely to accept the investment
opportunity it had during the year if residual income were used as a performance measure instead of
ROI? Explain you answer.
3. The Presser Division is a separate investment center with Lawton Industries. Identify and describe
the items Presser must control if it is to be evaluated fairly by either the ROI or residual income
performance measures.

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Question 1.15 – Standard Lock
Ted Crosby owns Standard Lock Inc., a small business that manufactures metal door handles and
door locks. When he first started the company, Crosby managed the business by himself, overseeing
purchasing and production, as well as maintaining the financial records. The only employees he
hired were production workers.
As the business expanded, Crosby decided to hire John Smith as the company’s financial manager.
Smith had an MBA and ten years of experience in the finance department of a large company.
During the interview, Smith mentioned that he was considering an offer from another company and
needed to know of Crosby’s decision within the next couple of days. Since Crosby was extremely
impressed with Smith’s credentials, he offered him the job without conducting background checks.
Smith seemed to be a dedicated and hard-working employee. His apparent integrity quickly earned
him a reputation as an outstanding and trusted manager.
Later in the year, Crosby hired another manager, Joe Fletcher, to oversee the production department.
Crosby continued to take care of purchasing and authorized all payments. Fletcher was highly
qualified for the position and seemed to be reliable and conscientious. After observing Fletcher’s
work for one year, Crosby concluded that he was performing his duties efficiently. Crosby believed
that Fletcher and Smith were both good managers whom he could trust and gave them expanded
responsibilities. Fletcher’s additional responsibilities included purchasing and receiving; Smith paid
all the bills, prepared and signed all checks, maintained records, and reconciled the bank statements.
Soon Crosby began taking a hands-off approach to managing his business. He frequently took long
vacations with his family and was not often at the office to check on the business. He was pleased
that the company was profitable and expected that it would continue to be profitable in the future
under the supervision of two qualified and trusted managers. One year after Crosby left the
management of the company to Smith and Fletcher, business began to experience a decline in
profits. Crosby assumed that it was due to a cyclical downturn in the economy. When Standard
continued to decline even as the economy improved, Crosby began to investigate. He noticed that
revenues were increasing but profits were declining. He also discovered that purchases from one
vendor had increased significantly as compared to the other five vendors. Crosby is concerned that
fraud may be occurring in the company.
REQUIRED:
1. Identify and describe four internal control deficiencies within Standard Lock Inc.
2. For each of the internal control deficiencies identified, recommend an improvement in

procedures that would mitigate these deficiencies.
3. If the company were to implement an ideal internal control system, can it guarantee that fraud
would not occur in future? Explain your answer.

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Question 1.16 – SieCo
SieCo is a sheet metal manufacturer whose customers are mainly in the automobile industry. The
company’s chief engineer, Steve Simpson, has recently presented a proposal for automating the
Drilling Department. The proposal recommended that SieCo purchase from Service Corp. two
robots that would have the capability of replacing the eight direct labor workers in the department.
The cost savings in the proposal included the elimination of the direct labor costs plus the
elimination of manufacturing overhead cost in the Drilling Department as SieCo charges
manufacturing overhead on the basis of direct labor costs using a plant-wide rate.
SieCo’s controller, Keith Hunter, gathered the information shown below in Exhibit 1 to discuss the
issue of overhead application at the management meeting at which the proposal was approved.
EXHIBIT 1
Average Annual Average
Average Annual Manufacturing Manufacturing
Date Direct Labor Cost Overhead Cost Overhead Rate
Current Year $4,000,000 $20,000,000 500%
Grinding
Category Cutting Department Department Drilling Department
Average Annual
Direct Labor $ 2,000,000 $1,750,000 $ 250,000
Average Annual
Overhead Cost 11,000,000 7,000,000 2,000,000
REQUIRED:
1. Using the information from Exhibit 1, describe the shortcomings of the system for applying
overhead that is currently used by SieCo.
2. Recommend two ways to improve SieCo’s method for applying overhead in the
Cutting and Grinding Departments.
3. Recommend two ways to improve SieCo’s method for applying overhead to accommodate the
automation of the Drilling Department.
4. Explain the misconceptions underlying the statement that the manufacturing overhead cost in
the Drilling Department would be reduced to zero if the automation proposal were
implemented.

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Question 1.17 – Giga
Giga Industries is a large publicly-held manufacturer of telecommunications equipment. The firm

developed the following forecast for the upcoming year.
Balance Sheet (thousands of dollars)
Current assets $100,000
Fixed assets 750,000
Accumulated depreciation 200,000
Net fixed assets 550,000
TOTAL ASSETS $650,000
Current liabilities $50,000
Long-term debt 150,000
Shareholders’ equity
Preferred stock 50,000
Common – par of $2 100,000
Common – premium 200,000
Retained earnings 100,000
450,000
TOTAL LIABILITIES & EQUITY $650,000
Income Statement (thousands of dollars)

Revenue $2,000,000
Depreciation expense 50,000

Other expenses 1,775,000
Earnings before interest & taxes 175,000
Interest expense 15,000
Taxes (40% effective rate) 64,000
Net income 96,000
Preferred stock dividends 5,000
Earnings for common stock $ 91,000
The Product Development Team has developed a new line of state-of-the-art switching devices and
is proposing a major capital investment of $200 million for a new division of the firm that will
manufacture and sell the new line. An extensive financial analysis was prepared using estimates for
each year of the estimated 10-year product life and presented to the Board of Directors indicating
that the project would result in a positive net present value (NPV) of $60 million and an internal rate
of return (IRR) of 25%. A board member commented that the project looked very promising but
expressed concern about the impact on earnings. The Controller was asked to develop a revised
forecast for the coming year assuming the project was approved.

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REQUIRED:
1. You are preparing the revised forecast for the Controller. For each of the following
assumptions show the Balance Sheet and/or Income Statement account that would be affected,
the amount of the change and if the change increases or decreases the account. Assume no
floatation costs on all financing.
a. The $200 million investment in fixed assets will be made on January 1 and will be
depreciated on a 10-year straight-line basis for financial statement and income tax purposes.
b. On January 1, $75 million of 10-year bonds will be issued at par with annual interest of 10%
payable December 31 with principle to be repaid at maturity.
c. On January 1, $25 million of Preferred Stock will be issued with an annual dividend rate of
14% payable December 31.
d. On January 1, 4 million new shares of common stock will be issued to net the firm $25 per
share. Common stock dividends are expected to be $0.50 payable December 31, as in the
original forecast.
e. During the initial year of operation, the new product is expected to produce cash revenue of
$60 million and have cash expenses (other than depreciation) of $30 million.
2. Assume the tax rate is expected to remain at 40% and taxes are paid on December 31, calculate
the change in net income resulting from the transactions in question A.

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Question 1.18 – Borealis Industries
Borealis Industries has three operating divisions – Sandstone Books, Corus Games, and Sterling
Extraction Services. Each division maintains its own accounting system and method of revenue
recognition.
Sandstone Books
Sandstone Books sells novels to regional distributors who then sell to independent bookstores and
retail chains in their territory. The distributors are allowed to return up to 25% of their purchases to
Sandstone, and the distributors have the same return allowance with the bookstores. The returns
from distributors have averaged 20% over the past five years. During the fiscal year just ended,
Sandstone’s sales to distributors totaled $15,000,000. At year end, $6,800,000 of sales are still
subject to return privileges over the next six months. The balance of the book sales, $8,200,000, had
actual returns of 19%. Sales from the previous fiscal year totaling $5,500,000 were collected in the
current fiscal year, with 21% of sales returned. Sandstone records revenue in accordance with the
method referred to as revenue recognition when the right of return exists as the company’s
operations meet all the applicable criteria for use of this method.
Corus Games
Corus Games supplies video arcades with new games and updated versions of standard games. The
company works through a network of sales agents in various cities. Orders are received from the
sales agents along with down payments; Corus then ships the product directly to the customer, f.o.b.
shipping point. The customer is billed for the balance due plus the actual shipping costs. During the
fiscal year just ended, Corus received orders for $12,000,000 from the sales agents along with
$1,200,000 in down payments. Customers were billed $150,000 in freight costs and $9,180,000 for
goods shipped. After an order has been shipped, the sales agent receives a 12% commission on the
product price. The goods are warranted for 90 days after sales, and warranty returns have been
about 3% of sales. Corus recognizes revenue at the point of sale.
Sterling Extraction Services
Sterling specializes in the extraction of precious metals. During the fiscal year just ended, Sterling
entered into contracts worth $36,000,000 and shipped metals worth $32,400,000. One quarter of the
shipments was made from inventories on hand at the beginning of the year, and the remaining
shipments were made from metals that were mined during the year. Sterling uses the completion-of-
production method to recognize revenue, because the operations meet the specified criteria, i.e.,
reasonably assured sales prices, interchangeable units, and insignificant distribution costs.
REQUIRED:
1. Define the two conditions that must be present for proper revenue recognition, according to the
revenue recognition principle.
2. Define and describe each of the following revenue recognition methods.

a. Percentage-of-completion method.
b. Installment-sales method.

21
3. Calculate the revenue to be recognized at the end of the fiscal year for
a. Sandstone Books.
b. Corus Games.
c. Sterling Extraction Services.

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Question 1.19 – Bellaton
Bellaton Industries is a manufacturing company located in Europe that has just completed the first
month of a new fiscal year. The Finance Department is reviewing the variances of actual results to
the master budget. The expenditures within the Marketing and Facilities departments make up the
majority of the fixed costs. The Sales Operations Department is responsible for revenue. The actual
results and master budget are shown below.
Master
Actual Budget
Units sold 18,000 16,000
Revenues €1,512,000 €1,360,000
Variable costs
Direct materials (792,000) (672,000)
Direct labor (252,000) (240,000)
Variable overhead (144,000) (128,000)
Contribution margin 324,000 320,000
Fixed costs (210,000) (215,000)
Operating income € 114,000 € 105,000
REQUIRED:
1. Prepare a flexible budget based on the actual sales volume.
2. a. Calculate the flexible-budget variance by comparing actual results to the flexible budget.
b. Explain the significance of these variances.
3. a. Identify and describe three benefits of measuring performance by comparing actual results
to the master budget.
b. Identify and describe one limitation of measuring performance by comparing actual
results to the master budget.
4. a. Identify and describe the different types of responsibility centers.

b. Identify the responsibility centers in the scenario.
5. Explain the difference between the sales-volume variance for operating income and the sales-
price variance.

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Question 1.20 – Ecoclock
Ecoclock manufactures four environmentally friendly consumer products, and the firm is organized
as four operating centers, each responsible for a single product. The main mechanism of each
product is the same and requires an identical initial processing step, although subsequent processing
for each product is very different. Ecoclock’s management has decided to centralize the initial
processing function and purchase new equipment that has a 40,000 unit annual practical capacity.
For budgeting and costing purposes, the initial processing function will be assigned to a new center,
Center E. Shown below is the budgeted production for the product centers.
Annual Production
Center A 5,000
Center B 7,500
Center C 4,000
Center D 6,000
A large part of the managers’ compensation is derived from bonuses that they receive for meeting or
exceeding cost targets. The mangers of centers A through D each agree that they should be charged
with the variable costs per unit that are delivered by Center E. However, they disagree about the
allocation of the fixed costs of Center E, primarily because they believe that the new equipment has
a much larger capacity than is necessary and they do not want to be charged with the cost of the
unused capacity. The fixed costs for Center E total $150,000, while the variable cost per unit is $6.
REQUIRED:
1. Assume fixed costs are allocated based on the proportion of units produced by each center. What
is Center D’s per unit cost?
2. What would be Center A’s per unit cost if Center E’s fixed costs are allocated based on practical
capacity?
3. Although allocating Center E’s fixed costs on a per-unit produced basis seems equitable, the
manager of Center C is worried about Center B reducing the number of units produced.
a. Calculate Center C’s per unit cost with no change in production.
b. If Center B reduces the number of units produced to 5,000, will Center C’s cost increase or
decrease and by how much?
4. The center managers are concerned that being charged for unused capacity will impact their
bonus.
a. Explain how company management could alleviate the concerns.
b. Identify three additional measures that could be used to evaluate manager performance.

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Question 1.21 - Edge
Edge Products is a global supplier of medical products. They have one primary product which is
manufactured in the United States, and two overseas subsidiaries which produce two key supplies
for the primary product. Both subsidiaries also sell these supplies to other companies. The U.S.
operation purchases the two supplies internally using transfer pricing. The supplies are of the same
quality as any available from other suppliers and there would be no benefit to purchasing the
supplies outside of the company. The market for the supplies is very competitive and prices are
stable. For performance purposes, the U.S. operation is evaluated by department, such as marketing,
IT, and sales, while the overseas operations are smaller and evaluated as a whole.
REQUIRED:
1. a. Define transfer pricing.

b. Identify the objectives of transfer pricing.
2. a. Identify the methods for determining transfer prices.

b. Explain the advantages and disadvantages of each method.
c. Based on the scenario, which method should this company select? Explain your answer.
3. How could tariffs, customs duties, or taxes affect transfer pricing and related performance
evaluation in this multinational company?
4. Identify and explain the four different types of responsibility centers.

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Question 1.22 - Zavod
Zavod Inc. produces a single product and utilizes a standard cost system. Zavod has budgeted
production costs for its first year of operations based on normal capacity of 11,000 units per
year. The production budget includes the following costs.
Direct materials $4.00 per finished unit

Direct labor $3.25 per finished unit
Variable manufacturing overhead $1.15 per finished unit
Fixed manufacturing overhead $2.85 per finished unit
In addition, Zavod has variable selling and administrative costs of $5.00 per unit and fixed selling
and administrative costs of $81,000.
During the year, Zavod produced 11,000 units and sold 10,000 units at $32 each. All variable costs
were exactly as expected on a per unit basis, and all fixed costs were exactly as expected in total.
Zavod's president has asked the controller to prepare an income statement under absorption costing
and an income statement under variable costing.
REQUIRED:
1. Explain how absorption costing and variable costing methods treat the following costs:
a. Direct materials.
b. Direct labor.
c. Variable overhead.
d. Fixed overhead.
e. Variable selling and administrative.
f. Fixed selling and administrative.
2. a. Calculate the unit cost to be used in valuation of the ending inventory under absorption
costing. Show your calculations.
b. Calculate the unit cost to be used in valuation of the ending inventory under variable costing.
Show your calculations.
3. a. Calculate operating income using absorption costing. Show your calculations.

b. Calculate operating income using variable costing. Show your calculations.
4. Explain why operating income calculated under absorption costing differs from operating
income calculated under variable costing.
5. a. Explain why absorption costing is required under U.S. GAAP.

b. Explain why variable costing is more appropriate for management decision-making.

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CMA Part 2 Essay Practice Questions
(Answers begin on Page 93)
Question: 2.1 – Foyle Inc.
Foyle Inc. has prepared the comparative income statements for the three most recent fiscal years that
are shown below. While profitable, Foyle has been losing market share and is concerned about
future performance. Also presented are data about Foyle’s largest competitor and the industry
average.
Year 1 Year 2 Year 3 Competitor Ind. Avg.

Revenue $20,000 $24,000 $30,000 $45,000 $28,000
Cost of goods sold 12,000 12,000 18,000 21,600 14,000
Gross profit 8,000 12,000 12,000 23,400 14,000
Sales and marketing 2,000 2,000 2,000 5,000 3,000
General and administrative 1,500 2,000 3,000 3,150 2,500
Research and development 1,500 2,000 1,000 4,000 1,500
Operating income $ 3,000 $ 6,000 $ 6,000 $11,250 $ 7,000
REQUIRED:
1. Using the three Foyle Inc. statements,

a. Prepare a comparative common-size statement using revenue as the base measure.
b. Prepare a common base-year income statement using Year 1 as the base year.
2. Calculate Foyle’s growth rate of both revenue and operating income for Year 2 and Year 3.
3. By evaluating Foyle’s performance against the performance of Foyle’s largest competitor and the
industry average, identify and discuss three areas that Foyle should target for further
investigation and performance improvement. Support your discussion with data.

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Question: 2.2 – Bockman Industries
Income statements for Bockman Industries, a retailer, are shown below for the past two years.
Year 2 Year 1
Revenues $6,400,000 $6,000,000
Cost of goods sold 3,100,000 2,850,000
Gross margin 3,300,000 3,150,000
Selling expenses 950,000 880,000
Administrative expenses 1,120,000 1,050,000
Loss due to strike 20,000 0
Interest expense 30,000 30,000
Income before taxes 1,180,000 1,190,000
Income tax expense 472,000 476,000
Income from continuing operations 708,000 714,000
Discontinued operations, net 72,000 0
Net income $ 780,000 $ 714,000
Earnings per share $2.50 $2.30
REQUIRED:
1. Prepare common-size income statements (vertical analysis) for Bockman Industries for the two
years presented.
2. Prepare a memo to the controller of Bockman identifying and describing a possible explanation
for each of the following.
a. An increase in sales along with the change in the gross margin percentage.
b. An increase in sales along with the increase in selling expenses.
c. An increase in sales along with the increase in administrative expenses.
3. Assume that Bockman has no preferred stock outstanding and any change in the number of
shares of common stock occurred at the beginning of Year 2. If the shareholders’ equity at the
end of Year 2 totaled $7,363,200, calculate Bockman’s book value per share.

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Question: 2.3 – Han Electronics Inc.
Han Electronics Inc. is an electronics retailer with a fitness equipment retailer subsidiary. Han is a
mature company with declining sales while the subsidiary is growing and profitable. The
management of Han is considering several strategic options for the company as a whole. They
considered purchasing additional companies to continue to diversify their product mix, or split out
some or all of the subsidiary into a separate company so that each company could go in a different
direction. Ultimately, the concern is that Han is failing. Management wants to maximize
shareholder value, turn the company around, and continue as a going concern.
REQUIRED:
1. a. Define mergers and acquisitions.

b. Does this scenario describe a merger or an acquisition?
c. Identify three possible synergies or benefits of mergers and acquisitions.
2. a. Identify and describe the following two types of divestitures: spin-offs and equity carve-outs.
b. Identify whether either of these divestiture types is described in the scenario above.
3. Define bankruptcy and identify the different types of bankruptcy.

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Question: 2.4 – OneCo, Inc.
OneCo Inc. produces a single product. Cost per unit, based on the manufacture and sale of 10,000
units per month at full capacity, is shown below.
Direct materials $4.00

Direct labor 1.30
Variable overhead 2.50
Fixed overhead 3.40
Sales commission .90
$12.10
The $0.90 sales commission is paid for every unit sold through regular channels. Market demand is
such that OneCo is operating at full capacity, and the firm has found it can sell all it can produce at
the market price of $16.50.
Currently, OneCo is considering two separate proposals:
 Gatsby, Inc. has offered to buy 1,000 units at $14.35 each. Sales commission would be $0.35
on this special order.
 Zelda Productions, Inc. has offered to produce 1,000 units at a delivered cost to OneCo of
$14.50 each.
REQUIRED:
1. What would be the effect on OneCo's operating income of each of the following actions?
a. Acceptance of the proposal from Gatsby, but rejection of the proposal from Zelda.
b. Acceptance of the proposal from Zelda, but rejection of the proposal from Gatsby.
c. Acceptance of both proposals.
2. Assume Gatsby has offered a second proposal to purchase 2,000 units at the market price of
$16.50, but has requested product modifications that would increase direct materials cost by $.30
per unit and increase direct labor and variable overhead by 15%. The sales commission would
be $.35 per unit.
a. Should OneCo accept this order? Explain your recommendation.
b. Would your recommendation be different if the company had excess capacity?
3. Identify and describe at least two factors other than the effect on income that OneCo should
consider before making a decision on the proposals.

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Question: 2.5 - PARKCO
Charlene Roberts is the controller for PARKCO, a company that owns and operates several parking
garages in a large Midwestern American city. Recently, the management of PARKCO has been
investigating the viability of building a parking garage in an area of the city that has experienced
rapid growth. Some years ago, PARKCO acquired the necessary land at a cost of $425,000, and
had demolished worthless buildings on the land at a cost of $72,000. Since then, the land has been
rented by various construction companies as a temporary storage site for building materials while the
construction companies completed projects in the area. PARKCO has averaged revenue of $5,000
per year for this use of the property.
Roberts is currently assembling financial information relating to the proposed garage. In addition to
the information already presented, she received from the CFO, John Demming, the following
projections:
Number of parking spaces in the proposed garage 840
Number of parking spaces rented at the monthly rate 420
Average number of parkers paying the daily rate 180

(for each of the 20 business days per month)
Fixed costs to operate the garage per month $30,000
Roberts estimates the monthly variable cost of servicing each monthly parker is $12, and that the
price of a monthly parking space would be $75. The estimated cost per daily parker is $2, and the
daily parking rate is expected to be set at $8. The parking garage would operate 20 business days
per month.
Roberts believes, based on PARKCO’s past experience with similar garages, that the projected
number of monthly and daily parkers was too high. When she questioned Demming he replied,
“This garage is going to be built no matter what your past experiences are. Just use the figures I
gave you.”
REQUIRED:
1. a. Define sunk cost and opportunity cost.

b. How are these two types of cost recorded in the accounting records?
c. Identify the sunk costs and opportunity costs, if any, in the PARKCO scenario and show the
amount of each.
2. Using the data in the scenario, calculate pre-tax operating income. Show your calculations.

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3. Roberts is uncomfortable with the implications of Demming’s statement and has turned to IMA’s
Statement of Ethical Professional Practice for guidance. According to this guidance,
a. identify the ethical principles that should guide the work of a management accountant.
b. identify the standards and describe how they would or would not apply in the circumstances
described.
c. identify the steps Roberts should take to resolve this situation.

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Question: 2.6 – Bell Company
Bell Company is a large diversified manufacturer organized into profit centers. Division managers
are awarded a bonus each year if the division exceeds profit goals. While division managers are
generally given control in operating their division, all capital expenditures over $500,000 must be
approved by the home office. Bob Charleson was recently appointed division manager of the Central
Division.
Twelve months ago, Charleson’s predecessor, who has been fired, was able to convince the home
office to invest $700,000 in modern manufacturing equipment with an expected life of 5 years.
Included within the $700,000 investment was a special packaging machine at a cost of $200,000.
This packaging machine has a 5-year useful life and a zero salvage value. Charleson has just learned
of a new packaging process that would save the Central Division $60,000 a year in packaging cost
over the 5-year life of the equipment. As a result of the introduction of new technology the current
packaging machine could be sold for $75,000. Acquisition and installation of the new packaging
process equipment would cost $210,000. Central Division’s cost of capital is 10% and it has an
effective income tax rate of 40%. The new equipment has a zero salvage value and is depreciated
over five years on a straight-line basis.
REQUIRED:
1. Calculate the net present value of acquiring the new packaging process. Show your calculations.
2. From a financial standpoint, should Bell Company invest in the new packaging technology?
3. Identify and explain three non-financial or behavioral factors that could cause
Charleson to change the investment decision made in the previous question.

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Question: 2.7 – Grandeur Industries
Grandeur Industries is currently in the process of reviewing capital budget submissions from its
various divisions. Grandeur uses the Capital Asset Pricing Model (CAPM) for a variety of purposes,
including the determination of benchmark investment returns. The company’s overall cost of capital
is 16% and its beta value is 1.2. The risk free rate is 4% and the expected return on the market is
14%. The following projects from different divisions are under consideration and there is no capital
rationing in effect.
Internal Rate Project

Project of Return Beta
A 16% 1.4
B 18% 1.6
C 12% 0.7
D 17% 1.1
REQUIRED:
1. a. Calculate the required return for all four projects. Show your calculations.
b. Which of the four projects under consideration should Grandeur accept? Support your
decision.
2. a. Define and explain beta.

b. Describe four factors that would impact the beta value that is chosen for use in
evaluating a project.
3. Identify alternative approaches to dealing with risk in capital budgeting.

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Question: 2.8 – Orion Corp.
Orion Corp. is a logistics and transportation company. The finance director, John Kochar, is in the
process of evaluating a number of proposed capital investment projects. The following information
relates to the firm’s finances.
 Some years ago the firm issued 10,000 bonds, each with a face value of $1,000 and paying an
annual coupon rate of 9.2%. These bonds are now trading at $1,040 per bond. A coupon
payment on these bonds was made yesterday and the bonds mature next year.
 The firm has no other debt or preferred stock outstanding.
 The firm has 2,000,000 shares of common stock outstanding. The stock is currently selling
for $14.80 per share and the firm is expected to pay a dividend of $1.48 per share next year.
The dividend is expected to grow at a constant rate of 4% per year in the foreseeable future.
 The firm’s corporate tax rate is 30%.
Kochar is reviewing the capital investment projects shown below. All projects are in Orion’s usual
line of business and are being considered independently of each other. The following information is
available. (Note that the net present values of the projects are estimated using the weighted average
cost of capital.)
Project Initial Outlay IRR NPV

A $450,000 17.0% $18,800
B $128,000 19.5% $2,300
C $262,000 16.2% $9,800
D $180,000 10.5% -$7,000
E $240,000 16.5% $22,500
F $160,000 11.1% -$900
The firm is also evaluating another proposed capital investment, project X, that is in a completely
different line of business from Orion’s usual operations. The project is expected to be financed from
the existing capital structure and does not fall within any capital rationing restrictions. The following
forecasted net after-tax cash flows relate to project X.
Year 0 Year 1 Year 2 Year 3 Year 4

-$200,000 $60,000 $80,000 $80,000 $80,000
REQUIRED:
1. Based on the information provided, calculate Orion’s weighted average cost of capital. Show
your calculations.
2. Referring to projects A through F, identify which projects should be accepted by Orion. Provide
a brief defense of the decision criteria that you have used in arriving at your recommendations.
3. Referring to project X, state whether the firm should use its weighted average cost of capital to
evaluate this project. Explain your answer.

35
4. Based on an analysis of two firms with operations similar to project X, Kochar has determined
that the project’s beta is 1.5. The risk-free rate is 5% and the market risk premium is 10%.
Calculate the net present value of project X and provide a recommendation on whether the
project should be accepted. Show your calculations.
5. In the past the firm has typically used the payback period method for evaluating risky projects
and accepted projects with a payback period less than 3 years.
a. Calculate the payback period for project X. Based on the firm’s payback period threshold,
what decision should the firm make regarding project X?
b. Provide one reason why using the payback period can result in the firm making a sub-optimal
decision.

36
Question: 2.9 – Global Manufacturing
Global Manufacturing is a Canadian company that processes a wide range of natural resources. Two
years ago the company acquired Zeta Manufacturing, a raw material processing firm located in the
United States. Over the last year, profits have fallen in the U.S.-based subsidiary. Laura Hammon,
the Manager of Manufacturing Accounting for Zeta Manufacturing, has been asked to identify the
problems that have impaired the firm’s profits.
She has reviewed the monthly production cost reports and discovered that the per unit costs have
been consistently increasing over the last year. Since the subsidiary used an actual cost system,
Hammon convinced the president and the production manager that a thorough assessment of each
product’s cost and the implementation of a standard cost system would help to solve the problem.
Within six months, Hammon installed a fully operational standard cost system for the division. After
several months of using the new cost system, Hammon is perplexed by unexplainable efficiency and
yield variances, which result in material inventory write-downs at the end of each month. The work-
in-process account is charged with the actual input costs of direct materials and direct labor, plus a
predetermined rate for normal spoilage. At the end of the month, the work-in-process account is
relieved by the standard cost per unit multiplied by the number of good units produced. This leaves a
balance in the account which should be consistent with the uncompleted units still in process, but
when compared to a physical inventory, there is a significant shortage of product in process,
resulting in a write-down of inventory.
When Hammon explained her problems to the production manager, he scoffed and said, “It’s your
crazy standard cost system that is messed up.” The production manager says that Hammon’s cost
system is poorly designed and does not track product costs accurately. Hammon is convinced there is
nothing wrong with the design of the standard cost system. She knows that the inventory write-
downs have no effect on the production manager’s compensation; however, she has heard that his
bonus is partially affected by the actual amount of spoilage. She decides to further examine the
provision for normal spoilage, as well as the actual spoilage reported.
During the following month, she monitored the records of disposal truck traffic that left the plant at
night. It would require only one truck nightly to dispose of the spoilage included in her standard
cost. The records reflected an average of three disposal trucks leaving the plant each night. This
unexplained traffic of disposal vehicles has caused her to be skeptical about the actual spoilage
reported by the production manager.
REQUIRED:
1. Does Hammon have an ethical responsibility to determine what may explain the unusual
inventory write-downs at Zeta Manufacturing? Support your answer by referring to the specific
standards outlined in IMA’s Statement of Ethical Professional Practice.
2. According to the IMA’s Statement of Ethical Professional Practice, what are the steps that
Hammon should take in order to resolve the situation?

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Question 2.10 – Cambridge Automotive
Cambridge Automotive Products (CAP) Inc., a multinational corporation, is a major supplier of a

broad range of components to the worldwide automobile and light truck market. CAP is in the
process of developing a bid to supply an ignition system module to Korea Auto Corporation (KAC), a
South Korean automobile manufacturer, for a new line of automobiles for the next four-year
production cycle. The Request for Proposal issued by KAC specifies a quantity of 200,000 modules
in the first year and 250,000 units in years 2 through 4 of the contract. CAP marketing specialists
believe that, in order to be competitive, a bid of 100,000 South Korean Won (KRW) per unit is
appropriate. Other relevant data are shown below.
 Manufacturing specialists estimate that a $12 million (U.S. Dollars) investment in equipment
(including installation) is required.
 The equipment is expected to last the 4-year life of the contract, at which time it would cost $1.4
million to remove the equipment which would be sold for a scrap value of $900,000.
 Direct labor and material expenses are estimated at $40 per unit.
 The change in indirect cash expenses associated with this contract is expected to be $3 million per
year.
 The new product will require additional investment in inventory and accounts receivable balances
at the outset, amounting to $1.2 million during the four-year time period. This investment will be
recovered at the end of the four-year contract.
 CAP is subject to U.S. income tax at an effective rate of 40%.
 For tax purposes, assume that the initial $12 million cost of the equipment is depreciated evenly
over the four-year period.
 The company economist estimates that the exchange rate will average 1,250 KRW per U.S. Dollar
for the four-year time period.
REQUIRED:
1. Calculate the after-tax incremental cash flows in U.S. Dollars for the following periods:
a. Period 0.
b. Period 1.
c. Period 4 operating cash flow
d. Period 4 terminal cash flow.
2. The assumptions used to develop the cash flows are subject to various degrees of estimation
error. For each of three different cash flow variables, identify and discuss one potential risk that
could affect the estimates made by CAP.

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Question 2.11 – City of Blakston
The City of Blakston owns and operates a community swimming pool. The pool is open each year
for 90 days during the summer months of June, July, and August. A daily admission is charged to
patrons of the pool. By law, 10% of all recreational and sporting fees must be remitted to a state
tourism promotion fund. The City Manager has set a goal that pool admission revenue, after
subtracting the state fee and variable costs, must be sufficient to cover the fixed costs. Variable
costs are assumed to be 15% of gross revenue. Fixed costs for the three-month period total $33,000.
The following budget for the pool has been prepared for the current year.
Adult admissions: 30 per day x 90 days x $5.00 $13,500

Student admissions: 120 per day x 90 days x $2.50 27,000
Total revenue 40,500
State tourism fee 4,050
Net revenue 36,450
Variable costs 6,075
Fixed costs 33,000
Expected deficit $ (2,625)
The City Manager is trying to determine what admission mix is necessary to break even and what
actions could be taken to eliminate the expected deficit.
REQUIRED:
1. Given the anticipated mix of adult and student admissions, how many total admissions must the
pool have in order to break even for the season?
2. Regardless of the admissions mix, what is the highest number of admissions that would be
necessary to break even for the season?
3. Regardless of the admissions mix, what is the lowest number of admissions that would be
necessary to break even for the season?

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Question 2.12 – Carroll Mining
Alex Raminov is a management accountant at Carroll Mining and Manufacturing Company

(CMMC), a large processor of ores and minerals. While working late one night to complete the
footnotes for the financial statements, Raminov was looking for a file in his supervisor’s office and
noticed a report regarding procedures for disposing of plant wastes. According to handwritten notes
on the face of the report, CMMC had been using a residential landfill in a nearby township to dump
toxic coal cleaning fluid wastes over a considerable period of time. The report stated that locating a
new dump site was urgent because the current one was nearing capacity.
Raminov realized that it was possible CMMC had been improperly disposing of highly toxic fluids
in a landfill that was restricted to residential refuse. Besides the obvious hazards to residents of the
area, there could be legal problems if and when the authorities were notified. The financial
consequences of clean-up actions, as well as the loss of CMMC's generally good environmental
reputation, could be catastrophic for the company.
Raminov asked his supervisor how this item was to be included in the footnotes and inquired
whether an accrual for clean-up costs was anticipated. His supervisor told him to "forget about this
matter" and that he had no intention of mentioning one word about waste disposal in this year's
financial statements.
REQUIRED:
1. Using the categories outlined in IMA’s Standards of Ethical Professional Practice, identify the
standards that are specifically relevant to Alex Raminov’s ethical conflict and explain why the
standards are applicable to the situation.
2. According to the IMA’s Standards of Ethical Professional Practice, what further steps, if any,
should Raminov take in resolving his ethical dilemma?
3. If he continues to be rebuffed by his employer, should Raminov notify the appropriate

authorities? Should he anonymously release the information to the local newspaper? Explain
your answers.

40
Question 2.13 – Langley Industries
Langley Industries plans to acquire new assets costing $80 million during the coming year and is in
the process of determining how to finance the acquisitions. The business plan for the coming year
indicates that retained earnings of $15 million will be available for new investments. As far as
external financing is concerned, discussions with investment bankers indicate that market conditions
for Langley securities should be as follows.
 Bonds with a coupon rate of 10% can be sold at par.

 Preferred stock with an annual dividend of 12% can be sold at par.
 Common stock can be sold to yield Langley $58 per share.
The company’s current capital structure, which is considered optimal, is as follows.
Long-term debt $175 million

Preferred stock 50 million
Common equity 275 million
Financial studies performed for Langley indicate that the cost of common equity is 16%. The
company has a 40% marginal tax rate. (Ignore floatation costs for all calculations.)
REQUIRED:
1. Determine how Langley should finance its $80 million capital expenditure program, considering
all sources of funds. Be sure to identify how many new shares of common stock will have to be
sold. Show your calculations.
2. Calculate Langley’s weighted average cost of capital that it could use to assess the viability of
investment options.
3. Identify how each of the following events, considered individually, would affect Langley’s cost
of capital (increase, decrease, no change). No calculations are required.
a. The corporate tax rate is increased.
b. Banks indicate that lending rates will be increasing.
c. Langley’s Beta value is reduced due to investor perception of risk.
d. The firm decides to significantly increase the percent of debt in its capital structure since
debt is the lowest cost source of funds.

41
Question 2.14 – Sentech Scientific
Sentech Scientific Inc., a manufacturer of test instruments, is in contract negotiations

with the labor union that represents its hourly manufacturing employees. Negotiations have reached
an impasse, and it appears that a strike is imminent. The controller has called the general accounting
manager into his office to discuss liquidity issues if and when a strike does occur.
The controller asks the accounting manager to recommend measures to assess liquidity if a strike
were to occur. Although some of the nonunion employees could probably produce test instruments
during a strike, the controller would rather be conservative and assume no shipments during this time
frame. Since the customers may go to other sources to obtain the products they need during a strike,
cash receipts for current outstanding amounts owed by customers may not be paid on a timely basis.
REQUIRED:
1. Define liquidity and explain its importance to Sentech.
2. Identify three measures that could be used to assess liquidity and explain how to calculate these
measures.
3. Determine which liquidity measure identified above would best fit the controller’s requirements,
and explain why. Include in your discussion the reasons why the other measures would not be as
appropriate.

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Question 2.15 – Ultra Comp
Ultra Comp is a large information technology firm with several facilities. The firm’s Audit
Committee has determined that management must implement more effective security measures at its
facilities. A Security Improvement Team has been formed to formulate a solution. Janet Lynch is
the financial analyst assigned to the team. She has determined that a six-year time horizon is
appropriate for the analysis and that a 14% cost of capital is applicable. The team is investigating
the following three vendors.
 Vendor A is a new entrant to the security industry and is in the process of introducing its security
system which utilizes new technology. The system would require an initial investment of $4
million and have a life of six years. A net cash outflow of $500,000 per year for salaries,
operation, maintenance, and all costs related to the system would also be required.
 Vendor B is an established firm in the security industry and has a security system that has been
on the market for several years. The system requires an initial investment of $1 million and will
have a useful life of three years. At the end of the three-year period, Ultra Comp would have to
replace the hardware at an estimated cost of $1,250,000, based on current technology. A net
cash outflow of $750,000 per year for salaries, operation, maintenance, and all other related costs
would also be required.
 Vendor C is a nationally recognized firm in the security industry and has proposed to Ultra
Comp that it provide a total security solution. Vendor C would provide all hardware and
personnel to operate and maintain a security system as called for by the specifications of Ultra
Comp for all its locations. Ultra Comp would be required to sign a six-year contract at a cost of
$1,400,000 per year.
REQUIRED:
1. Ultra Comp utilizes the Net Present Value (NPV) method to quantify the financial aspects of
corporate decisions. Calculate the NPV of each of the three alternatives.
2. Based on financial considerations, which of the three alternatives should the team recommend?
Explain why.
3. Define sensitivity analysis and discuss how Ultra Comp could use this technique in analyzing the
three vendor alternatives.
4. Identify and briefly discuss three non-financial considerations that the Ultra Comp team should
consider prior to making a recommendation to senior management.

43
Question 2.16 – Right-Way
Right-Way Stores is a chain of home improvement stores with 150 locations. Right-Way has
identified an attractive site for a new store and Jim Smith, Director of Financial Planning, has been
asked to prepare an analysis and make a recommendation for or against opening this proposed new
store.
In preparing his analysis, Smith has determined that the land at the proposed site will cost $500,000
and the new store will cost $3.5 million to build. The building contractor requires full payment at
the start of construction, and it will take one year to build the store. Right-Way will finance the
purchase of the land and construction of the new building with a 40-year mortgage. The mortgage
payment will be $118,000 payable annually at year end. Fixtures for the store are estimated to cost
$100,000 and will be expensed. Inventory to stock the store is estimated to cost $100,000.
Concerned about the possibility of rising prices, the company expects to purchase the fixtures and
inventory at the start of construction. Advertising for the grand opening will be $50,000, paid to the
advertising agency on retainer at the start of construction. The new store will begin operations one
year after the start of construction.
Right-Way will depreciate the building over 20 years on a straight-line basis, and is subject to a 35%
tax rate. Right-Way uses a 12% hurdle rate to evaluate projects. The company expects to earn after-
tax operating income from the new store of $1,200,000 per year.
REQUIRED:
1. What is Right-Way’s total initial cash outflow? Show your calculations.
2. Calculate the annual expected cash flow from the proposed new store. Show your calculations.
3. Right-Way management evaluates new stores over a five-year horizon as management believes
there is too much uncertainty after 5 years of operation. Calculate the Net Present Value (NPV)
for the store for the first 5 years of operation. Show your calculations.
4. Based solely on your answer to C, would you recommend that Right-Way build this store?
5. How would you use sensitivity analysis to test your confidence in the recommendation? No
calculations are required.

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Question 2.17 – Hi-Quality Productions
Amy Kimbell was recently hired as an accounting manager for Hi-Quality Productions Inc., a
publicly-held company producing components for the automotive industry. One division, Alpha,
uses a highly automated process that had been outsourced for a number of years because the capital
investment required was high and the technology was constantly changing. Two years ago, the
company decided to make the necessary capital investment and bring the operation in house. Since
all major capital investments must be approved by the Board of Directors, the budget committee for
the Alpha Division recommended the $4 million investment to the Board, projecting a significant
cost savings.
In her new job as accounting manager, Kimbell is on the budget committee for the Alpha Division.
The Board has requested from the committee a post-audit review of the actual cost savings. While
working on the review, Kimball noted that several of the projections in the original proposal were
very aggressive, including an unusually high salvage value and an excessively long useful life. If
more realistic projections had been used, Kimbell doubts that the Board would have approved the
investment.
When Kimbell expressed her concerns at the next meeting of Alpha’s budget committee, she was
told that it had been the unanimous decision of the committee to recommend the investment because
it was thought to be in the best long-term interest of the company. According to the committee
members, the post-audit report would not discuss these issues; the committee members believe that
certain adjustments to the review are justified to ensure the success of the Alpha division and the
company as a whole.
REQUIRED:
1. Using the categories outlined in IMA’s Statement of Ethical Professional Practice, identify the
standards that are specifically relevant to Kimbell’s ethical conflict and explain why the
identified standards are applicable to the situation.
2. According to IMA’s Statement of Ethical Professional Practice, what specific actions should
Kimbell take to resolve her ethical conflict?

45
Question 2.18 – Madison
David Burns is the Manager of the Electrical Division of Madison Inc. The budget for the
upcoming year has just been finalized and is summarized below.
Budget Component Amount

Revenue $17,050,000
Direct labor (300,000 hours @ $20/hr) 6,000,000
Employee benefits 2,400,000
Tools and equipment 1,800,000
Materials 2,000,000
Material procurement and handling 200,000
Overhead 3,100,000
Pretax profit $1,550,000
The budget meets the firm’s general guideline of a pretax profit equal to 10% of cost. Various
components of the budget can be described as follows:
 Direct labor represents the wage costs of employees (craft personnel, job site supervisors,
engineers, etc.) who work on specific projects and are directly billable to customer
projects. Madison charges this to customers based on the number of hours employees
work on the project times the average wage per hour.
 Employee benefits include the cost to Madison of paid time off (vacations, holidays, and
sickness), pensions, health and life insurance, and payroll taxes. This is charged to
customers as a percent of direct labor.
 Tools and equipment includes the cost of small tools, larger equipment such as cranes,
backhoes and generators, and the cost of vehicles including maintenance, fuel, insurance,
etc. This is charged to customers as a percent of direct labor charged to the job.
 Materials include materials acquired by Madison for use on customer projects, the cost of
which is passed directly on to the specific customers.
 Material procurement and handling represents the cost incurred by Madison to purchase,
warehouse, and deliver materials (referenced in the above bullet point) to job sites. This
is charged to customers as a percent of the material cost.
 Overhead includes the salary and benefit costs of employees not directly chargeable to
projects (administrative and corporate staff as well as senior management) and other
corporate expenses for facilities and supplies, most of which are relatively fixed. This is
charged to customers as a percent of all other costs incurred on the project.
REQUIRED:
1. David Burns received a call from Colby Architects asking for a price quote for a component of
electrical work to be done on an office building project. Based on the detailed specifications,
Burns estimated that the job would require 10,000 direct labor hours and materials costing
$200,000. He decided to develop a cost proposal for other cost elements based on the
percentages inherent in the budget, including a pretax profit equal to 10% of cost. Determine the
amount of the quote. Show your calculations.

46
2. Madison measures the performance of its managers, including Burns, based on their ability to
achieve budget targets, focusing on pretax profit as a percent of billable cost for each project
completed. Identify three advantages and three disadvantages of a performance measurement
and incentive compensation system linked to the budget for a firm such as Madison.
3. Two weeks after submitting his bid, Burns received a call from Colby stating that if Madison
could meet the lowest fixed cost bid of $695,000, then it would be awarded the contract.
Identify the factors that Burns should consider in deciding whether to accept the fixed price of
$695,000.
4. If Burns decides to accept the contract for the fixed price of $695,000, identify two
reasons that Burns can use to justify his decision. Explain your answer.

47
Question 2.19 – GRQ Company
GRQ Company is a privately-held entity that refines a variety of natural raw materials used as
primary inputs for the steel industry. The firm has done well over the last several years and most
members of senior management have received bonuses well in excess of 60% of their base salaries.
Also, both the CFO and the CEO have earned bonuses in excess of 100% of their base salaries. GRQ
has projected this trend of successful earnings and bonuses to continue.
All-American Steel Company (AAS) has tendered a very generous offer to acquire GRQ. At the
same time, several top GRQ executives who own over 40% of GRQ’s stock, have learned that the
primary supplier of their major raw material will not renew their contract at the end of the current
fiscal year. GRQ has no other vendors available within the United States to competitively provide
this raw material in the magnitude needed to support their continued record of profitable operations.
As part of the due diligence process, an analyst with AAS has asked John Spencer, controller of
GRQ, if he knows of any material event that would impact earnings over the next several years.
Spencer, who also participates in the bonus program, is aware that GRQ’s primary supplier will no
longer provide raw materials to the firm beyond the end of the current fiscal year. He spoke with
Bob Green, the CFO of GRQ, telling him that while the profit projections for the remainder of the
current year will match the earnings of prior years, it is obvious that projected earnings for the next
year will be greatly reduced. Green informed Spencer that the executive committee had met and
decided that only members of top management were to be made aware of the situation with their key
supplier. Accordingly, Spencer should not inform AAS of the situation with the supplier.
REQUIRED:
1. Referring to the specific standards outlined in IMA’s Statement of Ethical Professional Practice,
identify and discuss Spencer’s ethical obligations.
2. According to IMA’s Statement of Ethical Professional Practice, identify the steps that Spencer
should take to resolve the dilemma.

48
Question 2.20 – CenturySound
CenturySound, Inc. produces cutting edge high-end audio systems that are sold primarily through
major retailers. Any production overruns are sold to discount retailers, under CenturySound’s
private label SoundDynamX. The discount retail segment appears very profitable because the basic
operating budget assigns all fixed expenses to production for the major retailers, the only predictable
market.
Several years ago, CenturySound implemented a 100% testing program. On average approximately
3% of production is found to be substandard and unacceptable. Of this 3% approximately 2/3 are
reworked and the remaining 1/3 are scrapped. However, in a recent analysis of customer complaints,
George Wilson, the Cost Accountant and Barry Ross, the Quality Control Engineer, have ascertained
that normal rework does not bring the audio systems up to standard. Sampling shows that about
25% of the reworked audio systems will fail after extended operation within one year. Unfortunately,
there is no way to determine which reworked audio systems will fail because testing will not detect
this problem. CenturySound’s marketing analyst has indicated that this problem will have a
significant impact on the company’s reputation and customer satisfaction if the problem is not
corrected. Consequently, the Board of Directors would interpret this problem as having serious
negative implications on the company’s profitability. Wilson has included the audio system failure
and rework problem in his written report that has been prepared for the upcoming quarterly meeting
of the Board of Directors. Due to the potential adverse economic impact, Wilson has followed a
long standing practice of highlighting this information. After reviewing the reports to be presented,
the Plant Manager was upset and said to the Controller, “We can’t trouble the Board with this kind
of material. Tell Wilson to tone that down. People cannot expect their systems to last forever.” The
Controller called Wilson into his office and said, “George, you’ll have to bury this one. The
probable failure of reworks can be referred to briefly in the oral presentation, but it should not be
mentioned or highlighted in the advance material mailed to the Board.” Wilson feels strongly that
the Board will be misinformed on a potentially serious loss of income if he follows the Controller’s
orders. Wilson discussed the problem with Ross, the Quality Control Engineer, who simply
remarked, “That’s your problem, George.”
REQUIRED:
1. Identify and discuss the ethical considerations that George Wilson should recognize in deciding
how to precede in this matter. Support your answer by referring to the specific standards
outlined in the IMA’s Statement of Ethical Professional Practice.
2. According to the IMA’s Statement of Ethical Professional Practice, what are the steps Wilson
should take in order to resolve the situation?

49
Question 2.21 – Romco
Alex Conrad, financial analyst for RomCo, is presenting two mutually exclusive capital budgeting
project proposals to the management team. The preliminary results for the net present value (NPV)
and internal rate of return (IRR) analyses of the two projects being discussed are as follows.
Initial Investment NPV IRR

Project 1 $822,800 $0 12.00%
Project 2 $300,000 $49,469 17.65%
Project 1 is expected to have a positive after-tax cash flow of $200,000 per year for six years after
the initial investment, and Project 2 is expected to have a positive after-tax cash flow of $85,000 for
six years after the initial investment. During the meeting, Conrad was asked to explain several
issues related to his analysis of the projects.
REQUIRED:
1. Because of volatility in the financial markets, the company’s cost of equity may be higher than
assumed in this analysis. This is important as RomCo is entirely equity financed.
a. What cost of equity was used in this analysis? Explain your answer.
b. Would an increase in the cost of equity affect the NPV and IRR of the projects, and thus the
desirability of undertaking the projects? Explain your answer.
2. There is a possibility that the corporate income tax rate may be lowered in the near future. If this
were to occur, how would this affect the NPV and IRR of the projects, and the desirability of
investing in the projects?
3. a. What is the payback period for each project? Show your calculations.
b. Identify and explain three weaknesses of using the payback period to decide on doing these
projects.

50
Question 2.22 – Kolobok
Kolobok, Inc. produces premium ice cream in a variety of flavors. Over the past several years, the
company has experienced rapid and continuous growth and is planning to increase manufacturing
capacity by opening production facilities in new geographic areas. These initiatives have put
pressure on management to better understand both their potential markets and associated costs.
Kolobok’s management identified three aspects of their current operation that could affect the new
market expansion decision: (1) a highly competitive ice cream market, (2) the company’s current
marketing strategy, and (3) the company’s current cost structure.
Since the company began operations in 1990, Kolobok has used the mark-up approach for
establishing prices for six-gallon containers of ice cream. The product prices include the cost of
materials and labor, a markup for profit and overhead cost (a standard $20), and a market
adjustment. The market adjustment is used to appropriately position a variety of products in the
market. The goal is to price the products in the middle of comparable ice creams offered by
competitors while maintaining high quality and high differentiation. Sales for 2007 based on
Kolobok’s mark-up pricing are presented below by product.
Material Market Unit Boxes Total

Total
Product & Labor Markup adjustment Price sold Materials
Sales
& Labor
Vanilla $29.00 $20.00 $1.00 $50.00 10,200 $295,800 $510,000
Chocolate 28.00 20.00 7.00 55.00 12,500 350,000 687,500
Caramel 26.00 20.00 2.00 48.00 12,900 335,400 619,200
Raspberry 27.00 20.00 2.00 49.00 13,600 367,200 666,400
Total 49,200 $1,348,400 $2,483,100
For the year 2007, Kolobok’s before-tax return on sales was 7%. The company’s overhead expenses
were $500,000, selling expenses $250,000, administrative expenses $180,000, and interest expenses
were $30,000. Kolobok’s marginal tax rate is 30%.
Kolobok is considering replacing mark-up pricing with target costing and has prepared the table
below to better compare the methods. Kolobok tries to appeal to the top 30% of the retail sales
customers, including restaurants and cafes. In positioning Kolobok’s products, three dimensions are
considered: price, quality, and product differentiation. Accordingly, there are three main competitors
in the market as follows.
Competitor A – Low cost, low quality, high standardization

Competitor B – Average cost, moderate quality, average differentiation
Competitor C – High cost, high quality, high differentiation
Competitor A Competitor B Competitor C Kolobok

Product Pricing Pricing Pricing Target Prices
Vanilla $49 $55 $55 $53
Chocolate 50 53 56 53
Caramel 51 50
Raspberry 51 52 50

51
Kolobok has also been reviewing its purchasing, manufacturing, and distribution processes.
Assuming that sales volumes will not be affected by the new target prices, the company believes that
improvements will yield a $125,000 decrease in labor expense and a 25% reduction in overhead
expense.
REQUIRED:
1. Describe target costing.
2. Analyze and compare the two alternative pricing methods: mark-up pricing and target costing.
3. Assuming that the sales volumes will not be affected by the new product pricing based on target
costing and that the process improvements will be implemented, calculate Kolobok’s before-tax
return on sales using the proposed target prices.
4. Recommend which pricing method (mark-up or target) Kolobok should use in the future and
explain why.

52
Question 2.23 - Pursuit of Profit
Firms employ different strategies in the pursuit of profit, with successful strategies often dictated by
the type of industries and markets in which the firms operate. Listed below are selected entries from
the financial reports of two firms (labeled “A” and “B”).
Firm A (in € millions)

Income Statement Items Balance Sheet Items
Net sales 120 Assets 273
Cost of goods sold 48 Liabilities 200
Selling, general and administrative expenses 18 Shareholders’ equity 73
Depreciation 6
Interest expense 23
Taxes 8
Firm B (in € millions)

Income Statement Items Balance Sheet Items
Net sales 74 Assets 168
Cost of goods sold 25 Liabilities 84
Selling, general and administrative expenses 11 Shareholders’ equity 84
Depreciation 2
Interest Expense 10
Taxes 7
The DuPont approach provides a useful way to compare the financial performance of firms.
REQUIRED:
1. What are two advantages of using the DuPont approach?
2. Calculate return on equity for both firms using the DuPont formula.
3. a. Calculate each firm’s debt to equity ratio.

b. Discuss how the use of leverage affects the financial risk of the firms.
4. Discuss why the use of higher levels of financial leverage may be appropriate for some firms, but
too risky for others.
5. One firm uses a higher degree of financial leverage, and yet their return on equity is similar to
that of the other firm. Discuss the other factors that impact return on equity with respect to Firms
A and B.
6. Identify two limitations of financial ratio analysis.

53
Question 2.24 - Edmonds
Edmonds Manufacturing is located in the northwest region of the U.S. The company is experiencing
tremendous growth in demand for its products. Management has discussed the distribution channel
as an impediment to the company’s ability to keep up with growing demand. Manufacturing
facilities have excess capacity to meet increasing orders, but the company will have difficulty getting
the products to the customers. The supply chain distribution manager has suggested the company
purchase a new building to expand the storage area near the distribution center. After some
collaborative research by the accounting and finance departments, the company found that a new
building will cost $25,000,000. The new building will have an estimated useful life of ten years with
no salvage value. Operating the new building will cost approximately $1,000,000 per year but the
new building will allow the company to increase sales significantly. Distribution managers believe
the new building will increase productivity to allow for additional sales of 500,000 units each year.
Marketing managers estimate the demand for the company’s product will increase 750,000 units
each year. The average contribution margin for the company’s products is $55. The company’s
effective income tax rate is 40%.
REQUIRED:
1. a. Define capital budgeting.

b. What two steps should Edmonds take in evaluating and implementing this project?
2. What are two qualitative factors Edmonds should consider before implementing this project?
3. Identify the relevant cash flows for the project on both a pretax and an after-tax basis. Show your
calculations.
4. a. Define Net Present Value (NPV).

b. Define Internal Rate of Return (IRR).
c. Identify one assumption of NPV and one assumption of IRR.
d. Discuss the decision criteria used in NPV and IRR to determine acceptable projects.
5. Explain one advantage and one disadvantage of IRR.
6. a. Define the payback method

b. Identify and explain two disadvantages of the payback method.

54
Question 2.25 - Vista
Vista Ltd., a closely-held firm, is trying to determine a benchmark for its cost of equity. Comparable
firms in the industry have a price/earnings ratio of 11, an average beta value of 1.05, a dividend
payout ratio of 40% of earnings, and a projected growth rate of 10%. For the fiscal year just ended,
Vista had earnings per share of $3.00 and is expected to achieve the industry average growth rate in
the coming year. Economic indicators show the risk-free rate is 5% and the return on the market is
15%.
REQUIRED:
1. Calculate Vista’s cost of equity using the dividend growth model. Show your calculations.
2. Calculate Vista’s cost of equity using the Capital Asset Pricing Model. Show your calculations.
3. Compare the dividend growth model to the Capital Asset Pricing Model, by identifying at least
three characteristics of each.
4. Identify and discuss three factors that impact a firm’s cost of equity.

55
Question 2.26 – Atlas Express
Atlas Express, established thirty years ago, provides mailing and shipping services worldwide. The
company has 50 office locations in the U.S. A recent economic recession and its lingering effects,
accompanied by the acceptance and growth of major new technological platforms, has had a
significant negative impact on the company’s revenue as mail and shipping volume has fallen
precipitously. Atlas anticipates that volume will decrease for the foreseeable future. During the past
year, the company purchased new equipment worth $41,800. Proceeds from sales of the old
equipment were $11,500 with a net gain of $1,700. Below are the balance sheets as of December 31,
20X2 and as of December 31, 20X1, and the income statement for the year ended December 31,
20X2.
Balance Sheets
December 31, 20X2 December 31, 20X1

Cash and cash equivalents $ 81,800 $ 148,800
Receivables, net 87,900 104,100
Advances and prepayments 15,400 12,000
Total current assets 185,100 264,900
Buildings, equipment and land, net 2,001,400 2,076,400
Total assets $ 2,186,500 $ 2,341,300
Compensation and benefits 915,300 360,000

Trade payables and accrued expenses 420,100 438,800
Deferred revenue-prepaid postage 386,800 349,700
Short-term portion of debt 744,600 750,000
Total current liabilities 2,466,800 1,898,500
Long-term debt 2,260,100 2,336,800
Total equity (2,540,400) (1,894,000)
Total liabilities and equity $ 2,186,500 $ 2,341,300

56
Income Statement
Year ended December 31, 20X2

Operating revenue $ 3,390,400
Compensation and benefits 3,234,500
Transportation 502,500
Depreciation and amortization 107,000
Other 184,700
Total operating expenses 4,028,700
Loss from operations (638,300)
Interest expense (8,100)
Net loss $ (646,400)
REQUIRED:
1. Use two financial ratios to analyze the liquidity of the company. Show your calculations and
explain your analysis.
2. Recommend two ways to improve liquidity.
3. a. Define bankruptcy.
b. Identify one advantage and one disadvantage of declaring bankruptcy.
c. Do you recommend bankruptcy for Atlas? Explain your answer.

57
Question 2.27 – Leather Manufacturer
A company manufactures leather purses using a labor force for the process of hand cutting and
sewing the leather. The company is considering changing the current manufacturing process by
using a new machine capable of cutting the leather. Workers would then assemble the precut pieces
into the finished product. The company anticipates selling 31,250 units at a selling price of $80 each.
The machine is available to lease at a cost of $550,000 per year with a ten-year lease commitment.
The lease is an operating lease. If the machine is not leased, the company will continue to utilize its
current hand cutting process. The projected income statements for next year are shown below.
Lease Equipment Continue Current Process

Sales $2,500,000 $2,500,000
Variable costs of goods sold 950,000 1,500,000
Contribution margin 1,550,000 1,000,000
Fixed costs 1,200,000 650,000
Operating income $ 350,000 $ 350,000
With identical operating incomes for next year, the company is not sure if it should lease the
equipment or continue with the current hand cutting process.
REQUIRED:
1. a. Explain two ways the concept of operating leverage influences this decision.
b. Calculate the degree of operating leverage for each option.
2. a. Calculate the expected increase in operating income for next year under each option
assuming sales increase by 5% in each option.
b. If the company expects sales to increase 5% each year for the next ten years, which option
should the company choose? Explain your answers.
3. Assume the company had the option to purchase the new equipment instead of lease. The
purchase would be financed with debt. What differences would the financial statements show
between purchasing the equipment and leasing the equipment?
4. Purchasing the equipment for $6,000,000 would lead to an annual cash savings of approximately
$500,000.
a. Calculate the payback period.
b. Describe two disadvantages of using the payback period.

58
Answer to Part 1 Practice Questions
Answer: Question 1.1 – Coe Company
1. Cumulative Number Cumulative Cumulative

of Units Average Time/Unit Total Time
1 500 500
2 500 x .9 = 450 450 x 2 = 900
4 450 x .9 = 405 405 x 4 = 1620
2. $25 x 500 hours x 4 units = $50,000 with no learning curve

$25 x 405 x 4 units = $40,500 with 90% learning curve
$50,000 - $40,500 = $9,500 savings
3. a. Budgetary slack is the practice of underestimating budgeted revenues, or overestimating

budgeted costs, to make budgeted targets more easily achievable.
b. Budgetary slack misleads top management about the true profit potential of the company,
which leads to inefficient resource planning and allocation as well as poor coordination of
activities across different parts of the company.
4. a. 1. 1,740 x (25.00 – [44,805/1,740]) = 1,305U

2. 25.00 x (1,740 – [4 x 500]) = 6,500F
b. Direct labor rate variance remains the same, but direct labor efficiency variance will
become $3000 negative, because actual hours 1740 is more than expected from 90%
learning curve 1620.
5. A factor that could cause an unfavorable price variance and a favorable efficiency variance is
using a higher-skilled labor force that would be paid more per hour but would work more
quickly.
6. Direct labor efficiency variance would be even more unfavorable if an 80% learning curve was
used. The lower number implies more benefit from learning.
7. For a new product, the company may have no way of forecasting the amount of improvement (if
any) from savings. The company may set up a production method that is more efficient than
prototype, but will not gain further efficiencies.

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Answer 1.2 – Law Services Inc.
1. A flexible budget allows the attorneys to tell how much of their unfavorable variance is due to
lower than planned billing hours and how much is due to performance issues such as the
negotiated billed amount or variable expenses. A master budget is static and any variance must
be analyzed further to determine its cause.
2. The flexible budget revenues are calculated by multiplying the actual billed hours by the budgeted
amount per billed hour. Then the budgeted variable expense per billed hour is multiplied by the
actual billed hours. The flexible budget variable expense is subtracted from the flexible budget
revenue. The results are compared to the actual results from last year.
3. 6,000 * 325 = 1,950,000 static budget revenue

5,700 * 275 = 1,567,500 actual revenue
1,950,000 - 1,567,500 = $382,500 unfavorable static budget revenue variance
5,700 * 325 = 1,852,500 flexible budget revenue
1,852,500 - 1,567,500 = $285,000 flexible budget variance
6,000 - 5,700 = 300 hours unfavorable sales volume
300 * 325 = $97,500 unfavorable sales volume variance
4. 6,000 * 50 = 300,000 static budget variable expense

300,000 - 285,000 = $15,000 favorable variable expense variance
5,700 * 50 = 285,000 flexible budget variable expense
285,000 - 285,000 = $0, so the variance is a sales volume variance

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Answer: Question 1.3 – Inman Inc.
1. a. Materials $400,000
$720,000/100,000 = $7.20
b. 10,000 beginning inventory + 100,000 manufactured – 106,000 sold = 4,000 units in ending
inventory; 4,000 x $7.20 = $28,800.
c. Sales (106,000 x $12) $1,272,000

Cost of Goods Sold:
Beginning inventory $ 72,000
Cost of goods manufactured (100,000 x $7.20) 720,000
- Ending inventory (28,800) 763,200
Gross profit 508,800
Less selling & administrative
Variable costs 80,000
Fixed costs 300,000 380,000
Income $ 128,800
2. a. Materials $400,000
$520,000/100,000 = $5.20
b. 4,000 units x $5.20 = $20,800
c. Sales $1,272,000
Less variable costs:
Manufacturing = $5.20 x 106,000 $551,200
Selling and administrative 80,000 631,200
Contribution margin 640,800
Less fixed costs:
Manufacturing 200,000
Income $ 140,800
3. The difference in incomes is caused by the treatment of fixed manufacturing overhead.

Absorption costing treats this cost as a product cost that is held in inventory until the goods are
sold; variable costing treats fixed manufacturing overhead as a period cost, showing it as an
expense immediately. Because inventory decreased, absorption costing would expense all of the
current month’s fixed manufacturing overhead as well as some of the costs that were previously
deferred in the prior period’s inventory; variable costing would only expense the current month’s
amount, resulting in a higher income.
4. a. The advantages of using absorption costing are:

It is required for external reporting.
It matches all manufacturing costs with revenues.

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b. The advantages of using variable costing are:
Data required for cost-volume-profit analysis can be taken directly from the statement.
The profit for a period is not affected by changes in inventories.
Unit product costs do not contain fixed costs that are often unitized, a practice that could
result in poor decision-making.
The impact of fixed costs on profits is emphasized.
It is easier to estimate a product’s profitability.
It ties in with cost control measures such as flexible budgets.
5. a. Top-down advantage: speed, control top-down disadvantage: little buy-in, top has less info
Bottom-up advantage: more likely to commit, disadvantage: may set easier targets
b. Best: top-down, cost of products most important, want to focus on control
c. Benchmark with outside examples, mutual learning about problems, balance

scorecard methods of evaluation.

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Answer: Question 1.4 – Smart Electronics
1. Model M-11:
Overhead cost allocated (per unit): [€80,000 / (650 + 150)] x 650 = €65,000 65000/1300=50
Gross margin per unit: €90-€10-€50=€30
Model R-24:
Overhead cost allocated (per unit): [€80,000 / (650 + 150)] x 150 = €15,000
15,000/1500=10
Gross margin per unit: €60-€30-€10=€20
2. Setups: €20,000 / (3 + 7) = €2,000

Components: €50,000 / (17 + 33) = €1,000
Material Movements: €10,000/(15+35)= €200
Model M-11:
(€2,000 x 3) + (€1,000 x 170) + (€200*15)= €26,000
Overhead cost allocated by ABC (per unit): €26,600/1300= €20.00
Gross margin per unit: €90-€10-€20.00=€60.00
Model R-24:
(€2,000 x 7) + (€1000 x 33) + (€200x35)= €54,000
Overhead cost allocated by ABC (per unit): €54,000/1,500=€36.00
Gross margin per unit: €60-€30-€36= -€6.00
3. Because the products do not all require the same proportionate shares of the overhead
resources of setup hours and components, the ABC system provides different results than the
traditional system. The traditional method use volume base allocation base which allocates
overhead costs on the basis of direct labor hours. The ABC system considers important
differences in overhead resource requirements by using multiple cost drivers and thus provides
a better picture of the costs of each product model, provided that the activity measures are
fairly estimated.
In the case of Smart Electronics, model R-24 uses more setups, components and material
movements which might not be reflected in the labor hours. The following table shows the
overhead allocated per unit and profit margin per unit under the current conventional costing
system and ABC. As indicated, model R-24 was previously under-costed and model M-11 was
over-costed.
Overhead Allocated per unit under the current costing system and ABC:
Current costing system ABC
Model M-11 €50 €20.00
Model R-24 €10 €36.00

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Gross Margin per unit under the current costing system and ABC
Current costing system ABC
Model M-11 €30 €60.00
Model R-24 €20 -€6.00
Smart Electronics’ management can use the information from the ABC system to make better
pricing decisions. After allocating overhead by ABC, it gives a clear cost picture that model R-
24 costs more to manufacture because it uses more setups, components and material
movements. The current price of $60 is inadequate in covering the total cost and results in
negative gross margin. Therefore, the company might decide to increase the price of the model
R-24. For model M-11, the previous overhead was overestimated given that it was allocated by
labor hours. Under ABC, only €60.00 of the overhead was allocated to every unit of Model M-
11. The management might reduce the price of model M-11 to make it more competitive.
4. Advantages: The ABC system better captures the resources needed for model M-11 and model
R-24. It identifies all of the various activities undertaken when producing the products and
recognizes that different products consume different amounts of activities. Hence, the ABC
system generates more accurate product costs.
Limitations:
ABC requires continuously estimating cost drivers, updating and maintaining the system, which
make the system relatively costly.
A complicated system is sometimes confusing to the top management
Estimation of cost of activities and selection of cost drivers sometime may cause estimation
errors which could results in misleading cost information.

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Answer: Question 1.5 – Ace Contractors
1. a. Four types of functional responsibilities that should be performed by different people

 Authority to execute transactions
 Recording transactions
 Custody of assets and
 Periodic reconciliations
b. Zhao could execute transactions by initiating a transfer and could record transactions by
entering the Joint Venture that was erroneous.
2. Attempted controls
 The company had physical controls over their checks
 The president authorized and signed all checks
 The company maintained pre-numbered check stock.
 The company had a prepared budget to compare to actuals to identify variances
Ways to strengthen
 Restrict fund on-line transfer ability.
 Randomly select audit expense transactions on a periodic basis
 Separate the incompatible duties
3. a. Three internal control objectives

 Effectiveness and efficiency of operations - operations should be as efficient as possible
 Compliance with applicable laws and regulations - care should be taken to follow and be in
compliance with all applicable laws and regulations
 Reliability of Financial reporting – financial data should be reliable and timely so that it can
be useful for management decisions or outside users.
b. Identify and describe five components of internal control.
Control Environment – sets the tone of an organization, influencing the control

consciousness of its people.
Risk Assessment – identify and analyze relevant risks as a basis for management
Control Activities – the policies and procedures that help ensure that management directives
are carried out.
Information and Communication
Information – systems support the identification, capture, and exchange of information in a
form and time frame that enable people to carry out their responsibilities.
Communication - providing an understanding to employees about their roles and
responsibilities.
Monitoring – assesses the quality of internal control performance over time.
4. Describe three ways internal controls are designed to provide reasonable assurance.
 Segregation of duties – assigning different employees to perform functions
 Reconciliation of recorded accountability with assets
 Safeguarding controls – limit access to an organization’s assets to authorized personnel.

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Answers: Question 1.6 – Small Parts
1. A good system of internal control is designed to provide reasonable assurance regarding

achievement of an entity’s objectives involving effectiveness and efficiency of operations,
reliability of financial reporting, and compliance with applicable laws and regulations.
2. Segregation of duties requires that no one person have control over the physical custody of an
asset and the accounting for it. There is no evidence to suggest Smallparts makes any effort to
account for the value of returned product, which may indeed be significant. The one salesperson
seems to be in charge of all aspects related to returned product, including authorizing the returns,
crediting the customers, receiving the returns, handling the physical custody, finding new
customers, concluding sales, shipping, billing, and collecting. Most of these rules should be
separated.
3. A good system of internal control suggests that four functional responsibilities be separated, and
handled by different individuals: (i) authority to execute transactions, (ii) recording transactions,
(iii) custody of assets involved in the transactions, and (iv) periodic reconciliations of the
existing assets to recorded amounts. Smallparts might improve its control over the inventory of
returned product by separating these responsibilities among four different individuals.
4. Separate responsibilities and duties. While the salesman may be assigned to work with
customers who return products, and find other customers for these products, other staff should
post credits to customer accounts following written policy. The products should be received,
inventoried, booked and shipped just like regular products.

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Answer: Question 1.7 – Michael Hanson
1. a. The objective of a compliance audit is to see how financial controls, operating controls
conform with established laws, standards, and procedures.
b. The objective of an operational audit is to appraise the efficiency and economy of
operations, and the effectiveness with which those functions achieve their objectives.
2. a. Transaction processing controls include: passwords to limit access to input or change data,
segregation of duties to safeguard assets, control totals to ensure data accuracy.
b. Virus protection controls include: ensuring that latest edition of anti-virus software is
installed and updated, firewalls set up to deter incoming risks, limit internet access to
business-related purposes to reduce chances of viruses.
c. Backup controls include identification of vital systems to be backup regularly, development
of disaster recover plan, testing of backup communications and resources
3. A sound disaster recovery plan contains the following components:

 Establish priorities for recovery process
 Identification of software and hardware needed for critical processes
 Identify all data files and program files required for recovery
 Store files in off-site storage
 Identify who has responsibility for various activities, which activities are needed
first
 Set up and check arrangements for backup facilities
 Test and review recovery plan
4. a. Bank deposits not always correspond with cash receipts. Cause: cash received after bank
deposits. Action: have a separate individual reconcile incoming cash receipts to bank
deposits.
b. Physical inventory counts sometimes differ from perpetual inventory record, and sometimes
there have been alterations to physical counts and perpetual records. Cause: timing
differences. Actions: limit access to physical inventory, require and document specific
approvals for adjustments to records,
c. Unexpected and unexplained decrease in gross profit percentage. Causes: unauthorized
discounts or credits provided to customers. Actions: establish policies for discounts credits,
document approvals.

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Answer: Question 1.8 - Brawn Technology, Inc.
1. The two fundamental types of internal audits are operational audits and compliance audits.
An operational audit is a comprehensive review of the varied functions within an enterprise to

appraise the efficiency and economy of operations and the effectiveness with which those
functions achieve their objective. An example would be an audit to assess productivity. Other
examples could include an evaluation of processes to reduce rework, or reduce the time required
to process paperwork or goods.
A compliance audit is the review of both financial and operating controls to see how they
conform to established laws, standards, regulations, and procedures. An environmental audit
would be an example of a compliance audit. Other examples of compliance audits could include
the review of controls over industrial wastes or the review of procedures ensuring that proper
disclosure is made regarding hazardous materials on site.
2. a. A compliance audit would best fit the requirements of the president of Brawn.
b. The objective of this compliance audit is to assure the president that the manufacturing
facility has appropriate policies and procedures in place for obtaining the needed permits, has
obtained all the required permits in accordance with the law, and that environmental and
safety issues are being properly addressed.
c. The assignment specifically is to address the proper use of permits, compliance with safety
regulations, and compliance with environmental standards. These issues can only be
properly addressed by conducting a compliance audit. Although financial and operational
areas might be involved, they would be secondary to the compliance issues. For example, a
financial impact could result from the evaluation of compliance with safety regulations. The
findings might result in additional expenditures for safety precautions or a reduction in the
company’s risk of being fined for lack of compliance.
3. To mitigate the president’s concern, the following activities and procedures could be
implemented.
 Set the tone at the top. The president should communicate to all employees that the company
expects appropriate business practices on the part of all employees in all divisions.
 Ensure that all employees have the necessary information to perform their duties. Keep the
lines of communication open. For example, involve senior mangers from the manufacturing
facility in monthly operational meetings for the whole company.
 Conduct regularly scheduled audits of compliance with applicable laws, regulations, and
standards.
 Periodically review and update policies, rules, and procedures to ensure that internal controls
prevent or help to detect material risks. Make sure all employees have access to the relevant
policies and procedures. For example, post the policies and procedures on the company’s
intranet.

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Answer: Question 1.9 – Thompson
1. The positive and negative behavioral implications arising from employing a negotiated transfer
price system for goods exchanged between divisions include the following:
Positive
 Both the buying and selling divisions have participated in the negotiations and are likely to
believe they have agreed on the best deal possible
 Negotiating and determining transfer prices will enhance the autonomy/ independence of
both divisions.
Negative
 The result of a negotiated transfer price between divisions may not be optimal for the firm as
a whole and therefore will not be goal congruent.
 The negotiating process may cause harsh feelings and conflicts between divisions.
2. The behavioral problems which can arise from using actual full (absorption) manufacturing costs
as a transfer price include the following:
a. Full-cost transfer pricing is not suitable for a decentralized structure when the autonomous
divisions are measured on profitability as the selling unit is unable to realize a profit.
b. This method can lead to decisions that are not goal congruent if the buying unit decides to
buy outside at a price less than the full cost of the selling unit. If the selling unit is not
operating at full capacity, it should reduce the transfer price to the market price if this would
allow the recovery of variable costs plus a portion of the fixed costs. This price reduction
would optimize overall company performance.
3. The behavioral problems that could arise, if Thompson Corporation decides to change its transfer
pricing policy to one that would apply uniformly to all divisions, including the following:
 A change in policy may be interpreted by the divisional managers as an attempt to decrease
their freedom to make decisions and reduce their autonomy. This perception could lead to
reduced motivation.
 If managers lose control of transfer prices and, thus, some control over profitability they will
be unwilling to accept the change to uniform prices.
 Selling divisions will be motivated to sell outside if the transfer price is lower than market as
this behavior is likely to increase profitability and bonuses.
4. The likely behavior of both “buying” and “selling” divisional managers, for each of the
following transfer pricing methods being considered by Thompson Corporation include the
following:
a. Standard full manufacturing costs plus a markup
The selling division will be motivated to control costs because any costs over standard cannot
be passed on to the buying division and will reduce the profit of the selling division.

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The buying division may be pleased with this transfer price if the market price is higher.
However, if the market price is lower and the buying divisions are forced to take the transfer
price, the managers of the buying division will be unhappy.
b. Market selling price of the product being transferred
This creates a fair and equal chance for the buying and selling divisions to make the most
profit they can. It should promote cost control, motivate divisional management, and
optimize overall company performance. Since both parties are aware of the market price,
there will be no distrust between the parties, and both should be willing to enter into the
transaction.
c. Outlay (out-of-pocket) costs incurred to the point of transfer, plus opportunity costs per unit.
This method is the same as market price when there is an established market price and the
seller is at full capacity. At any level below full capacity, the transfer price is the outlay cost
only (as there is no opportunity cost), which would approximate the variable costs of the
goods being transferred.
Both buyers and sellers should be willing to transfer under this method because the price is
the best either party should be able to realize for the product under the circumstances. This
method should promote overall goal congruence, motivate managers, and optimize overall
company profits.

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Answer: Question 1.10 - Biscayne Industries
1. Benefits of using a flexible budget are:

a. As a planning tool, the flexible budget allows management to estimate income at more than
one level of output. This aids in allocating resources and allowing management to plan for
sufficient resources to meet its needs.
b. As an evaluation tool, actual results are compared with standard costs for actual output. This
provides for a fairer comparison and allows for variance computations to better assess
performance.
c. Make better use of historical budget information to improve future planning.
d. As an evaluation tool, comparing actual results to the flexible budget will not hide poor
performance. If output is less than budgeted, comparing actual costs for a lower number of
units with master-budgeted costs for a greater number of units will most likely yield
favorable variances even though cost inefficiencies may have existed.
2. Sales $55,000,000
Cost of goods sold:
Variable costs (55,000,000/50,000,000 = 10% increase;
30,000,000 – 20,000,000 = 10,000,000 original VC;
10,000,000 * (1+10%) 11,000,000
Fixed costs 20,000,000
Gross profit $24,000,000
Selling and administrative costs 12,000,000
Operating income $12,000,000
3. Three reasons sales increased but income decreased are:

a. Fixed costs increased. Increased output could have moved the company outside of its
relevant range, causing fixed costs to be higher than budgeted. Increased sales could have
been the result of more advertising dollars spent than originally planned.
b. The sales price was lowered, resulting in higher total sales but a lower contribution margin
per unit. Income decreased because the total increase in sales was not of sufficient volume to
be greater than the total increase in variable costs.
c. The income statement was prepared using absorption costing. Inventory could have
decreased throughout the year, causing fixed manufacturing overhead held in beginning
inventory to be expensed during the current year.
d. The product mix changed. More units of the low contribution margin products and fewer
units of the high contribution margin products were sold than planned.
4. Zero based budgeting: Preparing a budget from the ground up, as though the budget were being
prepared for the first time. Alternative means of conducting activities and alternative budget
amounts are evaluated. Also, all expenses are justified and fully explained. Every line of item
must be approved.

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Answer: Question 1.11 – Brown Printing
1. Absorption costing (also called full costing) includes fixed manufacturing overhead cost in the
cost of inventory. This method is required by GAAP and has been prepared using the traditional
external reporting format (gross margin format). Under this method, the fixed manufacturing
overhead was treated as a product cost. Only the portion of fixed manufacturing overhead
assigned to the sold units was expensed in the current period.
Variable costing includes only variable costs (direct labor, direct material, variable
manufacturing cost) in the cost of inventory. Fixed manufacturing overhead is included in the
income statement as a period cost.
2. a. Direct materials $15 + Direct labor $6 + Variable manufacturing overhead $4 = Unit Cost of
Goods sold $25.
b.
Sales $900,000
Variable cost of goods sold
($25 x 10,000 units) 250,000
Variable selling 30,000
Contribution margin 620,000
Administrative expenses 160,000
Net income $220,000
3. a. The unit cost of goods sold is calculated as follows:

Direct materials + Direct labor + Variable manufacturing overhead + Fixed manufacturing
overhead = $15 + 6 + 4 + ($240,000/15,000 books) = $15 + 6 + 4 + $16 = $41.
b.
Sales revenue $900,000
Cost of goods sold 410,000
Gross margin 490,000
Selling expenses 30,000
Administrative expenses 160,000
Net income $300,000
4. a. Advantages of variable costing

 It makes better sense to expense fixed manufacturing overhead since it will be incurred each
period regardless of the number of units sold or produced.
 No incentive to overproduce inventory because profit is strictly a function of sales volume
(not production volume).
 Better for internal decision making since this method breaks costs out into variable and fixed
components.
 Contribution format supports cost-volume-profit analysis and other short-run decision
making.

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b. Limitations of absorption costing
 The fixed manufacturing overhead assigned to the unsold units has been absorbed on the
balance sheet as part of the inventory cost.
 Any difference between the number of units produced and the number of units sold will
change the results.
 This method can lead to managers overproducing inventory to obtain better financial
results.
 This method is not useful for internal decision making since it does not break out variable
and fixed costs to support cost-volume-profit analysis.
5. The $80,000 difference in net income under the two methods represents the value of the fixed
manufacturing overhead included ending inventory. 5,000 more books were produced than sold.
The fixed manufacturing overhead at $16 per unit means $16 * 5,000 = $80,000 more is included
in ending inventory under absorption. Under variable, this $80,000 is expensed, reducing net
income.
6. Throughput costing is known as an extreme version of variable costing. It is also known as

super-variable costing. Under throughput costing, direct material is the only inventoriable cost.
Direct labor and variable manufacturing overhead are treated as period costs. Fixed
manufacturing overhead is treated as a period cost, the same as under variable costing.

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Answer: Question 1.12 - TruJeans
1. The sales staff has not presented the controller with a unique expected level of sales, but rather
sales numbers under various scenarios. The controller could use the expected sales in the
budget, which is the summation of the anticipated sales under each scenario times the probability
of that scenario. The controller would need to estimate the probability of each scenario in order
to complete the task.
2. Under direct costing, fixed manufacturing costs are expensed rather than being added to the
inventorial cost of each unit. Thus, it is not necessary to determine the allocation of fixed costs to
individual units.
3. At first glance, job order costing appears to make more sense, as each pair of jeans is literally
unique, given that the buyer’s name is stitched on the back pocket. However, in reality, process
costing should be used, because jeans will be produced continually, and for cost purposes, will
be same for each pair.

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Answer: Question 1.13 – Sonimad Sawmill
1. a. Relative sales value method at split-off
Product Monthly Output Sales Price Split-off Value % of Sales Allocated Costs
Studs 75,000 $ 8 $ 600,000 46.15% $ 461,539

Decorative pieces 5,000 60 300,000 23.08% 230,769
Posts 20,000 20 400,000 30.77% 307,692
Totals $1,300,000 100.00% $1,000,000
b. Physical output (volume) method at split-off
Product Monthly Output % of Output Allocated Costs
Studs 75,000 75.00% $ 750,000

Decorative pieces 5,000 5.00% 50,000
Posts 20,000 20.00% 200.000
Totals 100,000 100.00% $1,000,000
c. Estimated net realizable value method
Product Monthly Output Sales Price Net Value % of Net Value Allocated Costs
Studs 75,000 $ 8 $ 600,000 44.44% $ 444,445

Decorative pieces 4,5001 100 350,0002 25.93% 259,259
Posts 20,000 20 400,000 29.63% 296,296
Totals $1,350,000 100.00% $1,000,000
Notes:
(1) 5,000 monthly units of output – 10% normal spoilage = 4,500 good units
(2) 4,500 good units x $100 = $450,000 – further processing costs of $100,000 = $350,000
2. Presented below is an analysis for Sonimad Sawmill comparing the processing of decorative
pieces further versus selling the rough-cut product immediately at split-off.. Based on this
analysis, it is recommended that Sonimad further process the decorative pieces as this action
results in an additional contribution of $50,000.

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Units Dollars
Monthly unit output 5,000

Less normal further processing shrinkage 500
Units available for sale 4,500
Final sales value (4,500 units @$100 each) $450,000
Less sales value at split-off 300,000
Differential revenue 150,000
Less further processing costs 100,000
Additional contribution from further processing $ 50,000

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Answer: Question 1.14 - Lawton Industries
1. a. Average investment in operating assets employed:
Balance end of current year $12,600,000

Balance end of previous year* 12,000,000
Total $24,600,000
Average operating assets employed** $12,300,000
*$12,600,000 ÷ 1.05
**$24,600,000 ÷ 2
ROI = Income from operations ÷ Average operating assets employed

= $2,460,000 ÷ $12,300,000
= .20 or 20%
b. Residual Income:
Income from operations $2,460,000
Minimum return on assets employed* 1,845,000
Residual income $ 615,000
*$12,300,000 x .15
2. Yes, Presser’s management probably would have accepted the investment if residual income
were used. The investment opportunity would have lowered Presser’s ROI because the expected
return (18%) was lower than the division’s historical returns as well as its actual ROI (20%) for
the year just ended. Management rejected the investment because bonuses are based in part on
the performance measure of ROI. If residual income were used as a performance measure (and
as a basis for bonuses), management would accept any and all investments that would increase
residual including the investment opportunity rejected in the year just ended.
3. Presser must control all items related to profit (revenues and expenses) and investment if it is to
be evaluated fairly as an investment center by either the ROI or residual income performance
measures. Presser must control all elements of the business except the cost of invested capital,
that being controlled by Lawton Industries.

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Answer: Question 1.15 Standard Lock
1. 1) Crosby, the owner is taking a hands-off approach. He is hardly around to check on the
business; 2) the two managers Smith and Fletcher have too much control without any
independent checks on them; 3) hiring policies to hire the right kind of employees are lacking;
Crosby does not screen the job applicants; he did not check any background references for Smith
and Fletcher; 4) proper internal controls such as segregation of duties, authorizations,
independent checks are not in place. Fletcher places purchase orders, and also receives materials.
Crosby is in charge of collecting the payments, maintaining records, reconciling the bank
accounts, preparing and signing checks, and approving payments. Lack of basic internal controls
seems to have opened the door for employees to commit fraud.
2. Proper internal controls must be in place so that opportunities to commit, and/or conceal fraud
are eliminated. In this case, the internal controls needed are: 1) segregation of duties; 2) system
of authorizations; 3) independent checks; and 4) proper documentation. No one department or
individual should handle all aspects of a transaction from beginning to end. No one person
should perform more than one functions recording transactions, and reconciling bank accounts
(as done by Crosby in this case). In a similar manner, Fletcher should not authorize purchases,
receive inventory and issue materials for production. The company should also separate the
duties of preparing and signing checks, especially because the same person has the authority to
approve payment.
There is a failure to enforce authorization controls. Crosby should authorize purchases and
approve payments. He might consider hiring another person so that the two tasks, record keeping
and bank reconciliation can be separated.
In addition to that, the company must have better hiring policies in place, they may require
vacations, conduct internal audits and have good oversight of employees.
Require vacations, conduct internal audits, owner/board oversight.
3. Even the best internal controls do not guarantee that fraud will be eliminated. These controls
provide reasonable, not absolute, assurance against fraud. Internal controls are not fraud-proof,
internal controls never provide absolute insurance that fraud will be prevented. Effectiveness
depends on competency and dependability of people enforcing the controls.

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Answer: Question 1.16 – SieCo
1. SieCo is currently using a plant-wide overhead rate that is applied on the basis of direct labor
costs. In general, a plant-wide manufacturing overhead rate is acceptable only if a similar
relationship between overhead and direct labor exists in all department, or the company
manufactures products which receive proportional services from each department.
In most cases, departmental overhead rates are preferable to plant-wide overhead rates because
plant-wide overhead rates do not provide
 a framework for reviewing overhead costs on a departmental basis, identifying departmental

cost overruns, or taking corrective action to improve departmental cost control.
 sufficient information about product profitability, thus, increasing the difficulties associated
with management decision-making.
2. In order to improve the allocation of overhead costs in the Cutting and Grinding Departments,
SieCo should
 establish separate overhead accounts and rates for each of these departments.
 select an application basis for each of these departments that best reflects the relationship of
the departmental activity to the overhead costs incurred, i.e., machine hours, direct labor
hours, etc.
 identify, if possible, fixed and variable overhead costs and establish fixed and variable
overhead rates for each department.
3. In order to accommodate the automation of the Drilling Department in its overhead accounting
system, SieCo should
 establish separate overhead accounts and rates for the Drilling Department.
 identify, if possible, fixed and variable overhead costs and establish fixed and variable
overhead rates.
 apply overhead costs to the Drilling Department on the basis of robot or machine hours.
4. Because SieCo uses a plant-wide overhead rate applied on the basis of direct labor costs, the
elimination of direct labor in the Drilling Department through the introduction of robots may
appear to reduce the overhead cost of the Drilling Department to zero. However, this change
will not reduce fixed manufacturing expenses such as depreciation, plant supervision, etc. In
reality, the use of robots is likely to increase fixed expenses because of increased depreciation
expense. Under SieCo’s current method of allocating overhead costs, these costs will merely
be absorbed by the remaining departments.

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Answer: Question 1.17 – Giga
1. a. $200 million depreciated over 10 years, straight line = $20 million annual depreciation.
Increases depreciation expense by $20 million. The purchase will decrease Cash and increase
Gross Fixed Assets by $200 million. The depreciation expense will increase Accumulated
Depreciation, and decrease Net Fixed Assets by $20 million.
b. Long term debt increases by $75 million. Cash, which is part of Current Assets, will also
increase by $75 million. The annual interest expense is $75 million x 10% = $7.5 million.
c. Increases Preferred Stock, part of Equity, by $25 million. Cash, part of Current Assets, will
increase by $25 million. The preferred dividend will increase by $25 million x 14% = $3.5
million.
d. Common stock, part of Equity, will increase by $2 par x 4 million = $8 million. Common
stock premium, part of Equity, will increase by $23 x 4 million = $92 million. Cash, part of
Current Assets, will increase by $25 x 4 million = $100 million.
e. Revenues increase by $60 million, operating expenses increase by $30 million, Cash
increases by $30 million.
2. The revised forecast is as follows.
Balance Sheet (Thousands of dollars)
Original Changes Revised

Current Assets 100,000 16,000 116,000
Fixed Assets 750,000 200,000 950,000

Accumulated Depreciation 200,000 20,000 220,000
Net Fixed Assets 550,000 180,000 730,000
TOTAL ASSETS 650,000 196,000 846,000

Current Liabilities 50,000 0 50,000
Long-Term Debt 150,000 75,000 225,000
Stockholders' Equity
Preferred Stock 50,000 25,000 75,000
Common - Par 100,000 8,000 108,000
Common Premium 200,000 92,000 292,000
Retained Earnings 100,000 (4,000) 96,000
450,000 121,000 571,000
TOTAL LIABILITIES & EQUITY 650,000 196,000 846,000

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Income Statement (thousands of dollars)
Original Changes Revised
Revenue 2,000,000 60,000 2,060,000
Depreciation Expense 50,000 20,000 70,000
Other Expenses 1,775,000 30,000 1,805,000
Earnings Before Interest & Taxes 175,000 10,000 185,000
Interest 15,000 7,500 22,500
Taxes (40% effective rate) 64,000 1,000 65,000
Net Income 96,000 1,500 97,500
Preferred Stock Dividends 5,000 3,500 8,500
Earnings for Common Stock 91,000 (2,000) 89,000

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Answer: Question 1.18 - Borealis Industries
1. According to the revenue recognition principle in SFAC No. 5, revenue should be recognized (1)
when it is realized or realizable and (2) when it is earned.
Realized: when goods or services are exchanged for cash or claims to cash.
Realizable: when assets received for goods or services are readily convertible to known amounts
of cash or claims to cash.
Earned: when the seller has substantially completed what it must do to be entitled to the benefits
represented by the revenues.
2.
a. Percentage-of-completion method: Recognizes revenues, costs, and gross profit as a
company makes progress toward completion of a long-term contract. Deferring recognition
until the completion of the contract would misrepresent the efforts and accomplishments of
the accounting periods during the contract. Generally, progress is measured on a cost-to-cost
basis where a company measures the percentage of completion by comparing costs incurred
to date with the most recent estimate of the total costs required to complete the contract. To
use this method, the following conditions should exist: (1) a firm contract price with a high
probability of collection, (2) a reasonably accurate estimate of costs, and (3) a way to
reasonably estimate the extent of progress to completion of the project.
b. Installment-sales method: Recognizes income in the period of collection rather than in the
period of sale. The underlying rationale of this method is that when there is no reasonable
approach for estimating the degree of collectability of the sales price, companies should not
recognize income until cash is received. Using the installment-sales method, both revenue
and costs are recognized in the period of sale but the gross profit related to those periods is
deferred until cash is collected.
3. a.
Sandstone Books: Sales $15,000,000
Less returns @20%* 3,000,000
Recognized revenue $12,000,000
*Although up to 25% of sales can be returned, prior experience indicates that 20% of sales is
the expected average amount of returns. The 19% returns on the initial portion of current
sales confirms that 20% of sales will provide a reasonable estimate.

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b.
Corus Games: Sales invoiced $ 9,180,000
Total sales to be invoiced $10,800,000*
= Completion rate 85%
Total down payments $1,200,000

x Completion rate .85
Down payments recognized $1,020,000
Sales invoiced $ 9,180,000

Down payments 1,020,000
Recognized revenue $10,200,000
*Orders less down payments ($12,000,000 - $1,200,000)
Warranty expense does not generally reduce the revenue recognized, particularly when there
is experience on which to estimate the expense. The warranty expense should be accrued at
the time of sale. Similarly, commissions are part of the cost of sales and should be expensed
at the time of sale.
c.
Sterling Extraction Services:
Percentage-of-completion cost to cost method
Current year costs to date $18,000,000

Estimated costs to complete $12,000,000
Estimated total costs $30,000,000
Percentage complete ($18,000,000/$30,000,000) 60%
Contract Price $36,000,000
Revenue to date $36,000,000@.60 $21,600,000

Less: Prior year revenue $14,400,000
Current year revenue $7,200,000
Less Current year expenses $8,000,000
Net Profit (Loss) for current year ($800,000)

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Answer: Question 1.19 - Bellaton
1. Flexible Budget
Units Sold € 18,000
Revenues 1,530,000 =18,000×(1,360,000/16,000)=18,000×85
Variable Costs
Direct Material (756,000) =18,000×(672,000/16,000)=18,000×42
Direct Labor (270,000) =18,000×(240,000/16,000)=18,000×15
Var. Overhead (144,000) =18,000×(128,000/16,000)=18,000×8
Cont. margin 360,000
Fixed costs (215,000)
Operating Income € 145,000
2. a.
Actual Flexible
Results Budget Variances
Units Sold € 18,000 € 18,000 0
Revenues 1,512,000 1,530,000 (18,000)
Variable Costs
Direct Material (792,000) (756,000) (36,000)
Direct Labor (252,000) (270,000) 18,000
Var. Overhead (144,000) (144,000) 0
Cont. margin 324,000 360,000 (36,000)
Fixed costs (210,000) (215,000) 5,000
Operating Income € 114,000 € 145,000 (31,000)
b. Revenues: unit price < €85

Direct Material: unit purchase price > €42
Direct Labor: labor rate < €15
Fixed costs: actual fixed costs lower than expected
3. a. Budgets promote coordination and communication among subunits within the company.
They provide a framework for judging performance and they motivate managers and other
employees.
b. Budgets can be time consuming, require everyone’s participation, and require adaptability to
changing circumstances.

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4. a. A responsibility center is a part, segment, or subunit of an organization whose manager is
accountable for a specified set of activities. The types of responsibilities centers include:
- Cost center – manager responsible for costs only
- Revenue center – manager is accountable for revenues only
- Profit center – manager is accountable for revenues and costs
- Investment center – manager is accountable for investments, revenues, and costs
b. The types of responsibility centers in the example include marketing and facilities
departments which are cost centers and the sales operations team which is a revenue center.
5. Sales-volume variance is the difference between flexible budget units and the static budget units
multiplied by the budgeted unit contribution margin.
Sales-price variance is the difference between actual price and budgeted price multiplied by the
actual quantity of input.

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Answer: Question 1.20- Ecoclock
1. Center D would be charged for the variable cost of the units, plus a portion of the fixed costs
equal to the total costs divided by the number of units produced:
$6 + $150,000 / 22,500 =$12.67
2. Using a “practical capacity” method, Center A’s fixed costs would be allocated based not on the
number of units produced, but rather on the number of units that it is capable of producing
(40,000).
$6 + $150,000 / 40,000 = $9.75
3. A 2,500 unit reduction in the number of units produced by Center B, would increase the per-unit
allocation of fixed costs.
Per unit cost based on production of 22,500 units:
$6 + $150,000 / 22,500 =$12.67
Per unit cost based on production of 20,000 units:

$6 + $150,000 / 20,000 =$13.50
Thus C’s units costs would increase by $0.83
4. a. Unused central capacity could be not allocated to operating centers, but to some centralized
expense. Management could be evaluated by other measures, diluting the over capacity.
b. Other evaluation measures could include quality, measured by customer satisfaction, or

reductions in returns, warranty claims; financial, measured by reductions in variable costs,
increases in sales; innovations; measured by new product features, or manufacturing
improvements.

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Answer: Question 1.21 - Edge
1. a. Transfer pricing is the price one subunit department or division charges for a product or
service supplied to another subunit of the same organization.
b. The objectives of transfer pricing are to focus managers’ attention on their own subunits and
to plan and coordinate actions across different subunits to maximize operating income for the
company as a whole. Transfer prices should help achieve a company’s strategies and goals
and fit its organizational structure. They should promote goal congruence and a sustained
high level of management effort. The transfer price should also help top management
evaluate the performance of individual subunits and their managers.
2. a. The three main ways to determine transfer prices are as follows:

 Market based transfer prices – top management may choose to use the price of a similar
product or service publicly listed, for example in a trade association web site. Also, top
management may select, for the internal price, the external price that a subunit charges
to outside customers.
 Cost based transfer prices – top management may choose a transfer price based on the
cost of producing the product in question. Examples include variable production cost,
variable and fixed production costs, and full cost of the product. Full cost of the product
includes all production costs plus costs from other business functions (R&D, design,
marketing, distribution, and customer service). The cost used in cost based transfer
prices can be actual cost or budgeted cost. Sometimes, the cost-based transfer price
includes a markup or profit margin that represents a return on subunit investment.
 Negotiated transfer prices. In some cases, the subunits of a company are free to
negotiate the transfer price between themselves and then to decide whether to buy and
sell internally or deal with external parties. Subunits may use information about costs
and market prices in these negotiations, but there is no requirement that the chosen
transfer price bear any specific relationship to either cost or market price data.
Negotiated transfer prices are often employed when market prices are volatile and
change constantly. The negotiated transfer price is the outcome of a bargaining process
between selling and buying subunits.
b. The advantages and disadvantages to each method are as follows.

Market based transfer prices generally lead to optimal decisions when three conditions are
satisfied. The market for intermediate product is perfectly competitive, interdependencies of
subunits are minimal and there are no additional costs or benefits to the company as a whole
from buying or selling in the external market instead of transaction internally.
- Achieves goal congruence when markets are competitive

- Is useful for evaluation subunit performance when markets are competitive.
- Motivates management effort
- preserves subunit autonomy when markets are competitive.
- However, market may or may not exist, or markets may be imperfect or in distress.
Cost based transfer prices are helpful when market prices are unavailable, inappropriate, or
too costly to obtain – for example, when the product is specialized or when the internal
product is different from the products available externally in terms of quality and customer
service.
- It often but not always achieves goal congruence.
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- It is difficult unless transfer prices exceeds full cost and even then is somewhat arbitrary for
evaluating subunit performance.
- It motivates management effort when based on budgeted costs, less incentive to control costs
if transfers are based on actual costs.
- Does not preserve subunit autonomy because it is rule based
- It is useful for determining full cost of products and services and it is easy to implement
Negotiated transfer prices result from a bargaining process and preserves division autonomy
because the transfer price is the outcome of negotiations. Each division manager is
motivated to put forth effort to increase division operating income but has a disadvantage of
the time and energy spent on the negotiation.
- Achieves goal congruence
- It is useful for evaluating subunit performance but transfer prices are affected by bargaining
strengths of the buying and selling divisions.
- It motivates management effort
- It preserves subunit autonomy because it is based on negotiations between subunits
- Bargains and negotiations take time and may need to be reviewed repeatedly as conditions
change.
c. This company should use market based market based transfer prices as market for the
products is competitive, interdependencies of subunits are minimal and there are no benefits
to the company as a whole from buying or selling in the external market instead of
transaction internally.
3. Since management is often evaluated on the basis of subunit profits, they often care deeply about
how transfer prices are set. Transfer prices can reduce income tax payments by reporting more
income in low tax rate countries and less income in high tax rate countries. However, the tax
regulations of different countries restrict the transfer prices that companies can use. Tariffs and
customs duties levied on imports can create similar issues. Companies have incentives to lower
transfer prices for products imported in to a country to reduce tariffs and customs duties.
4. The four types of responsibilities centers are

Cost center – the manager is accountable for costs only
Revenue center – the manager is accountable for revenues only
Profit center – the manager is accountable for revenues and costs
Investment center – the manager is accountable for investments, revenues and costs

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Answer: Question 1.22 - Zavod
1. The only cost treated differently between the two methods is fixed overhead. Under both
methods, direct materials, direct labor, and variable overhead are considered product costs, and
are assigned to the units produced. Those costs remain as an asset as the cost of ending
inventory on the balance sheet for unsold units. Those costs attached to units that have been sold
appear as expenses in the income statement. Under both methods, both variable and fixed selling
and administrative costs are expensed as incurred. The only cost treated differently between the
two methods is fixed overhead. Under absorption costing, fixed overhead is considered a
product cost. Each finished unit absorbs a portion of the fixed overhead cost. Under variable
costing, fixed overhead is treated as period cost, and is expensed as incurred.
2. a. Under absorption costing, each unit will be carried in finished goods inventory at $11.25:

Variable Overhead $1.15 per finished unit
Fixed Overhead $2.85 per finished unit
Total $11.25
b. Under variable costing, each unit will be carried in finished goods inventory at the variable
production cost of $8.40:

Variable Overhead $1.15 per finished unit
Total $8.40
3. a. Absorption costing income statement:

Sales (10,000 x $32) $320,000
Cost of goods sold (10,000 x $11.25) 112,500
Gross Profit $207,500
Selling and administrative
Variable (10,000 x $5.00) $50,000
Fixed 81,000 131,000
Operating income $ 76,500
b. Variable costing income statement:

Sales (10,000 x $32) $320,000
Variable cost of goods sold (10,000 x $8.40) 84,000
Manufacturing contribution margin $236,000
Variable selling and administrative (10,000 x 5.00) 50,000
Contribution margin $186,000
Fixed costs:
Overhead (11,000 x $2.85) $31,350
Operating income $ 73,650

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4. In years when the number of units produced is greater than the number of units sold, such as in
this first year, absorption costing net income will be higher than variable costing net income
because under absorption costing, some of the fixed overhead will be associated with finished
goods, an asset on the balance sheet. Under variable costing, all of the fixed overhead is
expensed.
5. a. Absorption costing is required under GAAP because in theory, all costs of production should
be treated as product costs, associated with finished goods inventory and carried as an asset
until the units are sold. Fixed overhead is a necessary cost of production, and is thus treated
as an inventoriable cost.
b. Variable costing is more appropriate for internal decision making, because it is not affected
by the level of production, as is absorption costing. Under absorption, net income will
increase as more units are produced due to the inventorying of fixed overhead. Such is not
the case under variable costing, where fixed overhead is expensed as incurred.

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Answer to Part 2 Practice Questions
Answer: Question 2.1 – Foyle Inc.
1. a.
Year 1 Year 2 Year 3
Revenue 100% 100% 100%
Cost of goods sold 60% 50% 60%
Gross profit 40% 50% 40%
Sales & marketing 10% 8.3% 6.7%
General & admin 7.5% 8.3% 10%
Research & development 7.5% 8.3% 3.3%
Operating income 15% 25% 20%
b.
Year 1 Year 2 Year 3
Revenue 100% 120% 150%
Cost of goods sold 100% 100% 150%
Gross profit 100% 150% 150%
Sales & marketing 100% 100% 100%
General & admin 100% 133% 200%
Research & development 100% 133% 66.7%
Operating income 100% 200% 200%
2.
Revenue
Year 2: ($24,000 - $20,000)/$20,000 = 20%
Year 3: ($30,000 – $24,000)/$24,000 = 25%
Operating income
Year 2: ($6,000 - $3,000)/$3,000 = 100%
Year 3: ($6,000 – $6,000)/$6,000 = 0%
3. Foyle’s gross profit margin 50% was comparable in Year 2 to competitor 52% and industry
average 50%, but Foyle has fallen to 40% in Year 3. Foyle’s operating income percentage 25%
was the same in Year 2 to competitor and industry average at 25%, but Foyle has fallen to 20%
in Year 3.
Foyle in Year 3 has lower Sales and marketing than Competitor and Industry Average (6.7% vs.
11.1% and 10.7%), but higher in General and admin (10% vs. 7% and 8.9%). Foyle’s Research
and development is substantially below both Competitor and Industry Average (3.3% vs. 8.9%
and 5.4%)

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Answer: Question 2.2 – Bockman Industries
1. Year 2 Year 1
Revenues 100.0% 100.0%
Cost of Goods Sold 48.4 47.5
Gross Margin 51.6 52.5
Selling Expenses 14.8 14.7
Administrative Expenses 17.5 17.5
Loss Due to Strike .3
Interest Expense .5 .5
Income before Taxes 18.4 19.8
Income Tax Expense 7.4 7.9
Income from Continuing Operations 11.1 11.9
Discontinued Operations 1.1 _____
Net Income 12.2 11.9
2. a. Sales increased but the gross margin percentage decreased. This could be caused by:
 a change in the product mix
 a decrease in the selling price which resulted in selling more units but if the cost per unit
did not change or increased, the gross margin percentage would increase
 an increase in the cost of goods that was not passed along to customers; sales could have
increased because competition did raise their prices
b. Selling expenses remained fairly constant as a percentage of sales. This could be caused by:
 nearly all of the selling expenses being variable costs
 increased advertising to boost sales
c. Administrative expenses remained at a constant percentage of sales. Since most of these

costs are fixed, when sales rise, the costs as a percentage of sales should decrease. The
constant percentage could be caused by:
 moving outside of the relevant range of Year 1’s activity, causing step-fixed costs to
increase
 poor budgeting procedures or poor cost controls that allow administrative spending in
proportion to sales
3. Number of shares outstanding = $780,000/$2.50 = 312,000

Book value = $7,363,200/312,000 = $23.60

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Answer: Question 2.3 – Han Electronic Inc.
1. a. A merger is the combination of two or more companies in which only one firm survives as
the legal entity. An acquisition is when one company acquires another as part of its overall
business strategy.
b. The scenario describes a potential strategic acquisition as management was hoping to work
on product mix.
c. Some of the synergies of a business combination are the economies realized where the
performance of the combined firm exceeds that of its previously separate parts. There are
economies of scale where the benefits of size cause the average unit cost to falls as volume
increases. Acquisitions can increase sales, market share, or help the company gain market
dominance. There may be other marketing and strategic benefits, or the acquisition might
bring technological advance to the product table, or it may fill a gap in the product line which
would enhance sales made throughout the firm. It may be possible for duplicate facilities to
be eliminated after a merger or departments like marketing, accounting, purchasing, and
other operations can be consolidated. The sales force may be reduced to avoid duplication of
effort in a particular territory. The companies may be able to concentrate a greater volume
of activity into a given facility and into a given number of people to have a more efficient
utilization of resources.
2. a. A spinoff is a form of divestiture resulting in a subsidiary or division becoming an

independent company. Ordinarily, shares in the new company are distributed to the parent
company’s shareholders on a pro-rata bases. An equity carve-out is a public sale of stock in
a subsidiary in which the parent usually retains majority control. Only the spin off is
described in the scenario above.
b. The spinoff would be if Electronics Inc were to decide to split the subsidiary off into its own
separate company.
3. The main types of bankruptcy are chapter 7 – which is liquidation, or the sale of assets of a
firm, and chapter 11 which is rehabilitation of an enterprise through its reorganization.

93
Answer: Question 2.4 – OnceCo Inc.
1. The cost to produce the units is irrelevant, because OneCo can sell all that it produces at a market
price of $16.50. The net realizable value per unit is $15.60 ($16.50 - .90).
a) The first option would decrease net income by $1,600. The net realizable value per unit sold
to Gatsby is $14.00 ($14.35 - .35). In order to supply Gatsby, OneCo would be displacing
sales in the regular market having a NRV of $15.60. That reduction of $1.60 per unit X
1,000 units would decrease net income by $1,600.
Alternate solution: Normal profit per unit is $4.40 ($16.50 – $12.10). The profit per unit
sold to Gatsby is $2.80 ($14.35 - $11.55). Gatsby cost is $11.55 ($4.00 + $1.30 + $2.50 +
$3.40 + .35).
The difference of $1.60 per unit ($4.40 – $2.80) X 1,000 units would decrease net income by
$1,600.
b) The second option would increase net income by $1,100. The extra units could be sold in the
regular market at a NRV of $15.60. The cost is $14.50. Thus, profits would increase by
$1.10 per unit, or $1,100 in total.
Alternate solution: Selling Price $16.50 – Cost to purchase from Zelda $14.50 – Sales
commission $.90 = profit per unit $1.10. Increase in net income $1.10 @ 1,000 units =
$1,100.
c) The third option would decrease income by $500. Regular business is unaffected. As
explained above, the 1,000 units bought cost $14.50 each, and the NRV of the new units sold
is $14.00. The net difference is .50 per unit.
Alternate solution: Action 1 Decrease in Net Income of $1,600 + Action 2 Increase in Net
income of $1,100 = Net Decrease in Net Income of $500.
2. a) Direct Material $4.00 + $.30 = $4.30. Direct Labor $1.30 @ 1.15 = $1.495. Variable
Overhead $2.50 @ 1.15 = $2.875. Cost $12.42 ($4.30 + $1.495 + $2.875 + $3.40 + .35).
Profit per unit $4.08 ($16.5+12.42). Market profit $4.40 ($16.50 - $12.10). Decrease in net
income ($4.08 - $4.40) = -.32 @ 2,000 = decrease $640. Do not accept proposal.
b) If there is excess capacity, accept the proposal, revenue would contribute to fixed costs.
3. Other factors to consider are: the effect on market price/competition, effect on sales
force/commissions, quality of Zelda products, and follow-on Gatsby business. There may be
other considerations. Some other considerations are: impact on employees; reaction of
customers.

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Answer: Question 2.5 PARKCO
1. a. Sunk cost is cost already incurred, and thus is irrelevant to the decision at hand.
b. Opportunity cost is the profit foregone (given up) by choosing one course of action over
another. Only sunk costs are recorded as incurred, because they result from transactions.
There is no accounting recording of events that could have happened (opportunity costs), so
they are not recorded in the accounting system.
c. The costs to buy and clear the land ($425,000 and $72,000) would be considered sunk costs,
as they have already been incurred. The annual rent that from the construction companies
(averaging $5000) would be considered opportunity costs going forward, because PARKCO
would have to give them up.
2. # of leases x (monthly rate – monthly cost) = monthly CM

420 x ($75 - $12) = $26,460 monthly CM
# of days x parkers/day x (daily rate – daily cost) = daily CM
20 x 180 x ($8 - $2) = $21,600 daily CM
$26,460 + 21,600 = $48,060 total CM

(30,000) fixed cost
$18,060 pre tax Operating Income
3. a. Honesty, Fairness, Objectivity & Responsibility
b. Under Competence: Prepare complete and clear reports and recommendations after
appropriate analysis of relevant and reliable information.
Under Integrity: Communicate favorable as well as unfavorable information and

professional judgment or opinions.
Under Credibility: Disclose fully all information that could reasonably be expected to
influence an intended user’s understanding of the reports, comments, and
recommendations presented.
Confidentiality – does not apply to this scenario
c. The controller has an ethical dilemma. In order to resolve her conflict, she needs to follow
her company’s policy if one exists. Next she needs to speak to her supervisor or next level
above, in this case the CFO. She may need to elevate to the Board of Directors. She may
need to discuss with an objective advisor, call ethics helpline, (IMA), or consult with an
attorney.

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Answer: Question 2.6 – Bell Company
1. The net present value is calculated as follows:

New packaging process equipment $210,000 x 1.00 $(210,000)
Sale of existing packaging equipment $ 75,000 x 1.00 75,000
Tax benefit from sale $ 34,000 x .9090 30,906
Depreciation tax shield - new $ 42,000 x .4 x 3.791 63,689
Loss of annual tax shield – old $ 40,000 x .4 x 3.170 (50,720)
Annual after-tax savings 10%@ 5 year $ 36,000 x 3.791 136,476
Net present value $ 45,351
Annual depreciation on old equipment $200,000/5 = $40,000

Book value at end of first year $200,000 - $40,000 = $160,000
Loss on sale of old equipment:

Sale price $75,000
Book value 160,000 ($85,000)
Tax benefit = $85,000 x 40% tax rate $34,000
Annual depreciation on new equipment $210,000/5 = $42,000
2. The net present value at 10%, the firm’s cost of capital, is positive. A positive NPV indicates
that the project earns more than the firm’s cost of capital, and thus should be accepted.
3. Non-financial and behavioral factors that could cause the company to change the investment
decision made solely on the basis of financial terms include:
 Charleson’s bonus may be negatively affected by the decision to replace the packaging
equipment with the new technology, since the sale yields a short-term accounting loss of
$85,000. Such a loss may cause the Central Division to miss its profit targets, and Charleson
to miss his bonus.
 What kind of a warranty will the new equipment have? Since the technology is new, there
may be some risk of it not working reliably.
 There will be a learning curve and therefore increased training costs.

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Answer: Question 2.7 – Grandeur Industries
1. a. & b. The Capital Asset pricing Model (CAPM) when used in an investment analysis context
postulates that the return on an investment should be at least equal to the Risk Free Rate
plus a Risk Premium. The Risk Premium is based on the risk (volatility) of the
investment relative to the overall market (as measured by Beta) times the incremental
return on the market above the risk free rate. The model can be expressed as follows;
Required Return  rf  (rm  rf )  
Where: rf = the Risk Free rate

rm = return on the market
= the Beta value for the investment, a measure of risk
For the various projects:

Project A: Required Return = 4% + (14% - 4%) x 1.4 = 18%
Since the Internal Rate of Return (IRR) of 16% is less than the required 18%,
the project should be REJECTED.
Project B: Required Return = 4% + (14% - 4%) x 1.6 = 20%

Since the Internal IRR of 18% is less than the required 20%, it should be
REJECTED.
Project C: Required Return = 4% + (14% - 4%) x 0.7 = 11%

Since the IRR of 12%, is greater than the required 11%, it should be
ACCEPTED.
Project D: Required Return = 4% + (14% - 4%) x 1.1 = 15%

Since the IRR of 17%, is greater than the required 15%, it should be
ACCEPTED.
The capital asset pricing model allows firms (users) to assess the size of risk
premium necessary to compensate for bearing risk. It is a way to estimate the
required rate of return on a security or investment. Once the required return has been
determined is lets the user know of the expected return from the investment is
sufficient to warrant acceptance of the investment.
2. a. Beta = Measure of a stock’s volatility in relation to market.

Market beta = 1 A stock that moves > market, beta > 1; if < market, < 1.
High beta stocks are riskier but potential for higher returns & vice versa.
b. Factors that have an influence on the Beta value for a project include:
 The industry that the Division undertaking the project is in and its risk characteristics.
 Experience the division has with similar projects, if any.
 Ability of the Division to realize estimated returns on projects in the past.
 Strength of the management team of the division.
 Level of competition expected.

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 The geographical location of the project. Certain countries are more risky to operate in
than others.
 The degree to which the project involves new technology or unproven operating
conditions.
3. a. Informal method. NPVs are calculated at the firms’ desired rate of return, and the possible
projects are individually reviewed.
b. Risk-adjusted discount rates. Adjusting the rate of return upward as the investment becomes
riskier
c. Certainty equivalent adjustments. Decision maker needs to specify the indifferent point to
choice between a certain sum of money and the expected value of a risky sum.
d. Simulation analysis. Based on different assumptions, computer is employed to generate

many examples of results.
e. Sensitivity analysis. Forecasts of NPVs under different scenarios are compared to each other
to evaluate how assumption changes about a certain variable may alter the NPV.

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Answer: Question 2.8 – Orion Corp.
1. The weighted average cost of capital for the firm can be computed as follows.
Market Value Proportion Cost

Bonds $10,400,0001 0.26 5.03
Common Stock $29,600,0002 0.74 14.04
Totals $40,000,000 1.00
(1). 10,000 × 1040.00 = $10,400,000.

(2). 2,000,000 × $14.80 = 29,600,000.
92.00  1000.00
(3). Price = $1040.00 = .
(1  kd )
1092
So, kd =  1  5%.
1040
D 1.48
(4). ke = 1  g   0.04  14.0%.
P0 14.80
WACC = 0.26 × 0.05(1 - 0.3) + 0.74 × 0.14 = 11.27%.
2. The ranking of projects based on the net present value, which is the preferred criterion, is as
follows.
Initial
Project Outlay IRR NPV
E $240,000 16.50% $22,500
A $450,000 17.00% $18,800
C $262,000 16.20% $9,800
B $128,000 19.50% $2,300
F $160,000 11.10% -$900
D $180,000 10.50% -$7,000
So, the firm should accept projects E, A, C and B. The reason for using the NPV is that this
criterion maximizes the value of the firm while using the IRR can give misleading results.
3. The weighted average cost of capital cannot be used to evaluate the project because it is not in
the same line of business as the firm’s current operations. It is likely that the project would alter
the firm’s business risk in which case using the weighted average cost of capital would be
inappropriate. The firm should use a project-specific hurdle rate that reflects the project’s
systematic risk.

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4. Based on the CAPM, the project’s hurdle rate = 0.05 + 0.10 × 1.5 = 20%.
The project’s net present value is:
NPV = (($60,000 * .833) + ($80,000 * .694 + ($80,000 * .579) + ($80,000 * .482)) - $200,000 =
-$9620.00
Since the NPV is negative the project should be rejected.
5. a. The project’s payback period = 2 + 60/80 = 2.75 years.

Based on the threshold payback period that the firm uses it would accept the project because
the firm recovers its initial investment in less than 3 years.
b. The project should be rejected because it has a negative NPV. The payback period leads to a
sub-optimal decision because it ignores the time value of money. The payback period also
ignores the cash flows in later years but in this case even with year 4’s net cash flows the
project’s NPV remains negative.

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Answer: Question 2.9 – Global Manufacturing
1. Yes, under the standards of “competency” and “objectivity,” Hammon must “maintain an
appropriate level of professional competence” to analyze the nature of the technical problem. She
must also prepare “complete and clear reports” to management, and after appropriate analysis,
report to them “relevant and reliable information” about what she believes may explain the
inventory unusual inventory write-downs.
The standard of professional competence requires Hammond to determine what may explain the
write-down based on available information. It is also requires members to “perform their
professional duties in accordance with relevant laws, regulations and technical standards” and to
“prepare complete and clear reports and recommendations after appropriate analysis of relevant
and reliable information has been performed.”
Under the standard of integrity, she needs to refrain from either actively or passively subverting
the attainment of the organization’s legitimate and ethical objectives. Under objectivity, she
would have a responsibility to communicate the information she found fairly and objectively
2. According to the Standards of Ethical Conduct, Hammon should follow the guidelines
established by the organization to resolve such ethical dilemmas. If such do not exit, or fail to
resolve the dilemma, she should follow the chain of command by going to her immediate
superior, which in this case would appear to be the division controller. If this is not successful,
she should proceed up the chain of command until the dilemma is resolved. This would include
the CEO of the division as well as the controller of Canadian parent company.
She should not disclose the nature of such problems unless it is legally prescribed to anyone who
is not an employee or one who is engaged by the organization. Hammon should clarify the
relevant ethical issues by confidential discussion with an objective advisor (e.g. IMA Ethics
Counseling Service) to obtain a better understanding of possible courses of action. She should
consult her own attorney as to her legal obligations and rights concerning the ethical conflict.
However, in this case, since a distortion of the financial statements or a similar situation does not
appear to exist, this step may not be necessary.
Finally, if the ethical conflict exists after exhausting all level of internal review, she may have no
other recourse on significant matters than the resign from the organization and submit an
informative memorandum to an appropriate representative of the organization. While it is
unlikely in this situation, since it does not appear that external fraudulent financial reporting
exists, and depending the nature of the overall nature and extent of the ethical conflict, it may
also be appropriate to notify other parties.

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Answer: Question 2.10 - Cambridge Automotive Products
1. The analysis shown below yields the following after-tax incremental cash flows:
a. Period 0 ($13,200,000)
b. Period 1 4,200,000
Year
$ Millions
Cash Flow Element 0 1 2 3 4
Revenue $16.0 $20.0 $20.0 $20.0
Equipment ($12.0)
Equipment Salvage $0.9
Equipment Removal ($1.4)
Direct Labor & Materials ($8.0) ($10.0) ($10.0) ($10.0)
Indirect Costs ($3.0) ($3.0) ($3.0) ($3.0)
Net Working Capital ($1.2) $1.2
Total Cash Flow Before Tax ($13.2) $5.0 $7.0 $7.0 $7.7
Cash Taxes ($0.8) ($1.6) ($1.6) ($1.4)
Net Cash Flow, After Tax ($13.2) $4.2 $5.4 $5.4 $6.3
Memo: Calculation of Cash

Taxes
Tax Profit Before Tax &
Depreciation $5.0 $7.0 $7.0 $6.5
Tax Depreciation ($3.0) ($3.0) ($3.0) ($3.0)
Tax Profit Before Tax $2.0 $4.0 $4.0 $3.5
c. The Period 4 operating cash flow is $5,400,000 calculated as follows.
Revenue $20,000,000
Direct labor & material (10,000,000)
Indirect costs (3,000,000)
Before tax cash flow 7,000,000
Tax effect1 (1,600,000)
After tax cash flow $ 5,400,000
1
$7,000,000 - $3,000,000 = $4,000,000 x 40% = ($1,600,000)

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d. The Period 4 terminal cash flow is $900,000 calculated as follows.
Equipment removal ($1,400,000)

Salvage 900,000
Working capital recovery 1,200,000
Before tax cash flow 700,000
Tax effect2 200,000
After tax cash flow $ 900,000
2
$700,000 - $1,200,000 = ($500,000) x 40% = $200,000
2. Cash flow variables with potential risks that could affect the estimates made by CAP include the
following.
 Volume estimates are generally subject to a high degree of estimation error due to the variety
of external factors that impact the volume realized in the future. Competitive forces,
consumer acceptance of the new product, general economic conditions are just a few of the
factors that could influence the ultimate demand realized for the new car by KAC, which
would impact the demand for ignition system modules from CAP. Since there are a number
of fixed costs, including equipment and indirect costs, deviations in volume could have a
significant impact on the cash flows and the financial success of the project.
 Exchange rates are another important variable. Since CAP is a U.S. company with a cost
structure consisting of U.S. dollar denominated expenses, there is exchange risk resulting
from a revenue stream in the Korean Won. The net cash flows from the project in U.S.
dollars will be dependent on the exchange rate in effect when each of the KRW denominated
payments is received.
 Direct costs are another potential variance given that the actual productivity of its workforce,
the reliability of its manufacturing systems, and unit materials costs could vary substantially
from what CAP projects. In a competitive bidding situation, there may be pressure to bid as
low as possible to increase the chances for success. If the firm has used “best case”
assumptions for its cost structure, negative variances in the assumptions for direct costs could
decrease the amount of cash flow generated from the project relative to expectations.
 The estimates for the cost of the equipment removal and the salvage value of the equipment
could vary significantly as these costs will occur several years in the future and could
negatively impact the expected cash flow.

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Answer: Question 2.11 - City of Blakston
1. The contribution margin is 75%1 or $3.75 per adult admission, and $1.875 per student admission.
The mix is 20% adult (30 ÷ 150) and 80% student (120 ÷ 150). The weighted average
contribution margin is:
WACM = .20($3.75) + .80 ($1.875) = $2.25
The breakeven point is Fixed cost ÷ WACM
$33,000 ÷ $2.25 = 14,667 per season.

1
100% - state fee of 10% - variable cost of 15%
2. The highest number to break even assumes that all admissions are students:
$33,000 ÷ $1.875 = 17,600 per season
3. The lowest number to break even assumes that all admissions are at the adult rate:
$33,000 ÷ $3.75 = 8,800 per season

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Answer: Question 2.12 - Carroll Mining and Manufacturing
1. The standards from IMA’s Statement of Ethical Professional Practice that specifically relate to
Alex Raminov and the situation at Carroll Mining and Manufacturing are the following.
Competence
Perform professional duties in accordance with relevant laws, regulations, and technical
standards. It appears that CMMC is not incompliance with the relevant laws and regulations
regarding the dumping of toxic materials; at a minimum, Raminov has an obligation to report
this situation to higher authorities in the company.
Confidentially
Keep information confidential except when disclosure is authorized or legally required. This
standard may or may not relate to the CMMC situation depending on the requirements of the
environmental regulations in effect in the jurisdiction where CMMC is operating. Raminov
may be required by law to disclose the information.
Integrity
Refrain from engaging in any conduct that would prejudice carrying out duties ethically.
Abstain from engaging in or supporting any activity that might discredit the profession.
If Raminov does not report the apparent illegal dumping to those in authority at CMMC, his
behavior would not be considered ethical under these standards and his lack of action would
discredit the profession.
Credibility
Communicate information fairly and objectively.
Disclose all relevant information that could reasonably be expected to influence an intended
user’s understanding of the reports, analyses, or recommendations.
Disclose delays or deficiencies in information, timeliness, processing, or internal controls in

conformance with organization policy and/or applicable law.
All of these standards make it clear that Raminov has an obligation to act objectively in this
matter and report the situation to those in authority at CMMC. The risks and exposures of
illegal dumping should be disclosed in the financial reports that Raminov is preparing.

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2. Initially, Raminov should follow CMMC’s policy regarding the resolution of an ethical
conflict. If there is no policy or the policy does not resolve the issue, he should consider the
courses of action recommended in IMA’s Statement of Ethical Professional Practice.
Since Raminov’s immediate supervisor appears to be involved in the dumping situation, he

should submit the issue to the next higher level. If the situation is not satisfactorily resolved,
Raminov should approach successive levels of authority, e.g., CFO, audit committee, Board of
Directors. He can also contact an IMA ethics counselor or other impartial advisor to discuss
possible courses of action. Raminov should consult an attorney regarding his legal obligations
and rights in this ethical conflict.
3. It is not considered appropriate for Raminov to inform authorities or individuals not employed
or engaged by CMMC unless he believes there is a clear violation of the law. In discussions
with his attorney, Raminov should clarify his obligations under the law. If CMMC does not
take action after Raminov has informed the appropriate in-house authorities, he may be
obligated to inform the regulatory agency involved. He should not under any circumstances
anonymously release this information to the local newspaper.

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Answer: Question 2.13 - Langley Industries
1. Financing plan (dollars in millions):
Current Percent of Funds Retained External

structure total Needed earnings sources
Debt $175 35% $28 $28
Preferred 50 10% 8 8
Common 275 55% 44 $15 29
Totals $500 100% $80 $15 $65
Financing sources will be as follows:
New Debt $28 million

New Preferred stock 8 million
Retained earnings 15 million
New Common stock1 29 million
Total $80 million
1
$29 million ÷ $58 per share = 500,000 new common shares
2. Weighted average cost of capital
% of Capital Weighted
Structure Cost Cost
Debt 35% 6.00%1 2.10%
Preferred 10% 12.00% 1.20%
Common 55% 16.00% 8.80%
Cost of Capital 12.10%
1
Pre-tax 10% x (1- tax rate) = 6.00%
3. a. If the corporate tax rate was increased, the after-tax cost of debt would be reduced, thereby
reducing the cost of capital. In other words, the tax shield of debt becomes more valuable to
the firm.
b. When the banks indicate they are raising rates, the rest of the debt market generally raises
rates. The higher cost of debt will increase the overall cost of capital.
c. Beta is a measure of risk. According to the Capital Asset Pricing Model, the cost of equity is
directly related to risk. As risk is reduced the cost of equity is reduced and correspondingly
the overall cost of capital is reduced.
d. In general, a significant increase in the percent of debt in the capital structure (especially in
this case where the current structure is deemed optimal), results in more risk for the firm.
This increases its cost of debt and its cost of equity. The increase in the cost of equity will
most likely offset the fact that debt has a lower relative. The result here is that the cost of
capital should increase.

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Answer: Question 2.14 - Sentech Scientific Inc.
1. Liquidity is the ability of an asset to be converted into cash without significant price concessions.
Liquidity is important to Sentech because current obligations will continue if there is a strike.
Understanding the company’s ability to meet its obligations even if normal cash receipts are not
forthcoming would give management an indication of whether or not – and for how long – it
could weather a strike. Lack of liquidity can limit a company’s financial flexibility, making it
unable to take advantage of discounts and other profitable opportunities. Liquidity problems can
also lead to financial distress or bankruptcy.
2. Measures of liquidity include the following.
 Current ratio: current assets/current liabilities

 Quick ratio (or acid-test ratio): (cash + marketable securities + accounts receivable)/current
liabilities. The quick ratio excludes inventory and prepaid expenses from cash resources.
 Cash ratio: (cash + marketable securities)/current liabilities
 Only cash and securities that are easily convertible into cash are used.
 Net working capital: current asset – current liabilities
 Net working capital ratio: net working capital/total assets
 Sales to working capital: sales/average net working capital
 Accounts receivable turnover: net sales/average gross receivables
 This ratio can also be calculated in days.
 Inventory turnover: cost of goods sold/average inventory
 This ratio can also be calculated in days.
3. Based on the parameters set down by the controller, either the quick ratio or the cash ratio would
be best. The reason that these ratios are best is because they focus on the most liquid assets,
excluding prepaid expenses and inventories. During a strike inventories would not be a source of
cash. The cash ratio excludes receivables as well, and would be the most conservative measure.
The cash ratio would reflect the fact that the collection of receivables would be slowed during a
strike.

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Answer: Question 2.15 - Ultra Comp
1. Net present value of each of the alternatives
Time Amount 14% PV Factor Present Value

Vendor A
Initial investment 0 $4,000,000 1.000 $4,000,000
Annual cash outflow 1-6 500,000 3.889 1,944,500
NPV $5,944,500
Vendor B
Initial investment 0 $1,000,000 1.000 $1,000,000
Replacement 3 1,250,000 0.675 843,750
Annual cash outflow 1-6 750,000 3.889 2,916.750
NPV $4,760,500
Vendor C
Annual cash outflow 1-6 $1,400,000 3.889 5,444,600
NPV $5,444,600
2. Ultra Comp should select Vendor B. It is the optimal choice from a financial point of view as it
meets the requirements at the lowest cost. Since the decision has already been made to
implement a new security system, the issue is to decide on a system that meets the requirements
at the lowest cost.
3. Sensitivity analysis is a tool to test the impact of changing investment assumptions on the
resulting net present values. The method helps determine the “sensitivity” of outcomes to
changes in the parameters. It shows how the output of the model depends on the input of the
model.
4. Non-financial factors that Ultra Comp should consider prior to making a recommendation
include the following.
 Vendor A technology may be more effective in the long term even though it is the highest
cost solution. However, there is a risk involved in the fact that this is new technology and
may not prove effective.
 Vendor B technology is known to be effective and should be satisfactory for the near term.
However, there is uncertainty in the long term.
 Since Vendor C is a nationally recognized leader, it may be in a better position to manage the
security of Ultra Comp, especially as new developments arise.
 Ultra Comp should review the management capability and the financial stability of each of
the vendors.
 Ultra Comp should contact previous clients of each of the vendors to determine their level of
satisfaction with the quality and customer service of each vendor.

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Answer: Question 2.16 – Right-Way
1. 500,000 + 3,500,000 +100,000 + 100,000 + (50,000 * (1-.35) = $4,232,500 million.
2. The scenario tells us that the after tax operating income is $1,200,000. We find the
depreciation expense by dividing the building cost into the depreciation period, $3,500,000 / 20
= $175,000 annual depreciation expense.
Assuming the interest on the mortgage is not considered when we discount a cash flow, or it is
included in (taken out to arrive at) the $1.2 million, and no change in working capital, we can
calculate the Cash Flow three ways:
a. Simply add the $1,200,000 and the $175,000 to get $1,375,000.
b. Find total net income: $1,200,000 after tax operating income / 1-.35 = $1,846,150 taxable
income. The tax on this is 646,154, getting us back to 1,200,000 net income. Add back the
175,000 depreciation to get $1,375,000.
c. Use depreciation tax shield: Start with the $1,846,154 taxable income. Adding the 175,000
depreciation, we get before tax cash flow of $2,021,154. The tax on this is 707,404, but the
depreciation tax shield is 61,250, resulting in 1,375,000 cash flow.
3. The factor for a five year annuity, at 12% from our table is 3.605. So the value of 5 years’ of
cash flow is $4,956,875. But the store will open, and cash flows will start 1 year after spending
the zero period costs, so this value needs to be discounted one more year, to $4,425,781.
The NPV is $4,425,781 – 4,232,500 = $193,281.
4. Yes, Right-Way should build the store. The positive NPV (even ignoring values past 5 years)
will add to the value of the company. The benefit of the future cash flows is greater than the
costs to open to the store.
5. Sensitivity analysis shows how much small changes in the inputs affect the decision. Especially
if we had a computer, we could try other assumptions about the store’s forecast after tax
operating income, the input with the most uncertainty. The costs of construction may also be
underestimated, even the tax rate and the hurdle rate may possibly change of the next five years.
How much will these have to change to turn a successful, positive NPV store, into an
unsuccessful negative NPV store?

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Answer: Question 2.17 - Hi-Quality Productions
1. The standards from IMA’s Statement of Ethical Professional Practice that specifically relate
to Amy Kimbell and the situation at Hi-quality Productions are the following.
Competence
Provide decision support information and recommendations that are accurate, clear, concise,
and timely.
Recognize and communicate professional limitations or other constraints that would preclude
responsible judgment or successful performance of an activity.
Amy Kimbell has an ethical conflict because she has been told to “keep quiet” about errors
she has discovered in the original budgeting process. The incorrect data used makes the
decision support data provided suspect and the decisions made based on that data risky.
Integrity
Refrain from engaging in any conduct that would prejudice carrying out duties ethically.
Abstain from engaging in or supporting any activity that might discredit the profession.
Amy Kimball has an ethical conflict as she has an obligation to disclose the errors in the
budgets presented but has been told not to. If she does not correct the situation, she will not be
carrying out her duties ethically and therefore will discredit her profession.
Credibility
Communicate information fairly and objectively.
Disclose all relevant information could reasonably be expected to influence an intended user’s
understanding of the reports, analyses, or recommendations.
It is clear that the budget committee has not been objective in its presentation of information
and therefore has distorted the decisions based on that information. Kimbell should correct the
information so that future expectations are realistic.
2. Initially, Kimbell should follow Hi-Quality Productions’ policy regarding the resolution of
an ethical conflict. If there is no policy or the policy does not resolve the issue, she should
consider the courses of action recommended in IMA’s Statement of Ethical Professional
Practice.
Kimbell should present her findings to her immediate supervisor. If her immediate supervisor
is involved in the incorrect budgeting situation or if the supervisor takes not action, she should
submit the issue to the next higher level. If the situation is not satisfactorily resolved, Kimbell
should approach successive levels of authority, e.g., CFO, audit committee, Board of Directors.
She can also contact an IMA ethics counselor or other impartial advisor to discuss possible

111
courses of action. Kimbell should consult an attorney regarding her legal obligations and
rights in this ethical conflict.

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Answer: Question 2.18 – Madison
1. Colby Quote based on Budget Proportions
Revenue Budget Colby Quote

$17,050,000
Direct Labor
Hours 300,000 10,000
Rate per hour 20 20
Total Amount 6,000,000 200,000
Employee Benefits 2,400,000

Percent of Direct Labor 40% 40%
Total Amount 80,000
Tools and Equipment 1,800,000

Percent of Direct Labor 30% 30%
Total Amount 60,000
Materials 2,000,000 200,000
Procurement & Handling 200,000

Percent of Material Cost 10% 10%
Total Amount 20,000
Subtotal 12,400,000 560,000
Overhead 3,100,000
Percent of Above Costs 25% 25%
Total Amount 140,000
Total Cost $15,500,000 700,000
Pretax Profit
Percent of Total Cost 10% 10%
Total Amount 70,000
Amount of Colby Quote $770,000
2. Madison's performance measurement system can be expected to produce the

following benefits:
 Aligning the performance measurement system with the budget results in everyone
working toward the same goals and targets.

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 Focusing on earning a profit on each job provides incentives to managers to continually be
cost conscious.
 If the firm is profitable, then employees will be able to share in the rewards. When the firm
is not profitable, it does not have the expense of bonuses.
Drawbacks to such a system include the following:
 If the budget is revised during the year, the firm faces the dilemma of changing the
performance measures, often upsetting employees.
 Although the overall target of 10% may be reasonable, a firm such as Madison cannot
expect every project to earn 10%. Focusing on all projects completed during the year may
be more realistic.
 Utilizing company average percentages for various cost elements may not be appropriate
for all projects. For example, some projects may utilize a significant amount of equipment
(as a percent of labor) compared to other projects. A more appropriate way to charge for
major equipment may be to have a rate per day (or per hour, as appropriate) for such
equipment and charge the customer based on the number of days (or hours) utilized.
3. Factors that David Burns should consider include:
 The overall workload for the firm. If there are other more profitable projects that could be
undertaken, then possibly this project should be turned down. On the other hand, if there
are no other alternative projects, this one could be advantageous even though it does not
show a 10% profit.
 Mr. Burns should identify the primary out of pocket (incremental, or marginal) costs for the
project, and compare that to the contract amount. If the out of pocket costs exceed the
contract amount, the job should be rejected. If the out of pocket costs are less than the
contract amount, then Madison would receive some contribution toward fixed costs. Direct
Labor ($200,000), Benefits (80,000), and Materials ($200,000) are the primary incremental
costs in this case and amount to $480,000. This leaves $215,000 (695,000 less 480,000) to
cover other costs, most of which are primarily fixed.
 Mr. Burns should assess the importance of a relationship with Colby. If Colby is a critical
customer, that would influence the decision. Also, if Colby has not been a customer
before, then it may be important to take the job for strategic reasons and establish a
relationship, even if this first job does not meet the target profit.
 Of course, Mr. Burns will be considering the impact on his performance of accepting a
project with a less than 10% profit. However, he should place the interests of his employer
above his own in making a decision on whether to accept the contract.
4. Reasons that Burns can use to justify his decision include:

 Strategic value of having Colby as a customer
 Other more profitable opportunities were not available.
 This project involved a significant amount of material costs that are a pass through to the
customer. Therefore, the practice of adding 25% for company overhead is not totally
appropriate in this case.

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Answer: Question 2.19 – GRQ Company
1. Under Competence, Spencer has a responsibility to “maintain an appropriate level of

professional competence.” He must perform his duties in accordance with relevant laws,
regulations and technical standards, e.g. FASB No. 5 – Accountancy for Contingencies.
Under Confidentiality, he must keep information confidential except when disclosure is

authorized or legally required and inform his subordinates of the same requirement. He must
refrain from using or appearing to use confidential information for unethical or illegal advantage
personally.
Under Integrity, Spencer must “avoid actual or apparent conflicts of interest and advise all
appropriate parties of any potential conflict.” He must also “refrain from engaging in any activity
that would prejudice his ability to carry out his duties ethically.” He should also “refrain from
engaging in any activity that would discredit the profession.”
Finally, under Credibility, Spencer must “communicate information both fairly and objectively.”
He should “disclose fully all relevant information that could reasonably be expected to influence
an intended user’s understanding of the reports and recommendations presented.”
2. According to IMA’s Statement of Ethical Professional Practice, Spencer should first follow the
established policies of the organization he is employed by in an effort to resolve the ethical
dilemma. If such policies do not exist, or are not effective, he should follow the steps as outlined
in “Resolution of Ethical Conflict”.
First, he should discuss the problems with his immediate superior except when it appears the
superior is involved. Since his superior is the CFO, who gave him the instructions to ignore the
situation and not consider the financial ramifications of non-disclosure, he should proceed to the
next higher level, which is the CEO of GRQ company. If this step is not successful in solving the
dilemma, he should proceed up the chain of command, which in this case would appear to be the
Board of Directors of GRQ.
However, he should note that except where legally prescribed, communication of such internal
problems should not be discussed with authorities or individuals not employed or engaged by the
organization.
Spencer should clarify relevant ethical issues by confidential discussion with an objective
advisor (e.g. IMA Ethics Counseling Service) to obtain a better understanding of possible
courses of action. He should consult his own attorney as to his legal obligations and rights
concerning the ethical conflict.
(*) – According to the provisions of the Sarbanes-Oxley Act of 2002 (SOX) , employees are to
be provided with a means to report such matters to top management of the organization, and
when deemed appropriate, may report these matters to the appropriate external parties (e.g. SEC,
Justice Department, EPA, etc.) as the matter dictates. Candidates should be given some credit
for being aware of this provision made by SOX.

115
Answer: Question 2.20 – CenturySound
1. According to the Statement of Ethical Professional Practice , Wilson in this situation has a
responsibility to demonstrate
 Competence by preparing complete and clear reports and recommendations after appropriate
analyses of relevant and reliable information.
 Confidentiality by refraining from disclosing confidential information acquired in the course

of their work except when authorized, unless legally obligated to do so.
 Integrity by communicating unfavorable as well as favorable information and professional

judgments or opinions as well as refraining from engaging in or supporting any activity that
would discredit the profession.
 Objectivity by communicating information fairly and objectively and disclose fully all
relevant information that could reasonably be expected to influence an intended user’s
understanding of the reports, comments and recommendations presented.
2. Wilson should first discuss this matter with his superior, the Controller, unless his superior is
involved in which case he should go to the next managerial level. If a satisfactory solution
cannot be reached with his superior, Wilson should move up the chain of command. Unless his
superior is involved, Wilson should inform his superior when he goes to higher levels of
management. If his superior is the CEO, Wilson should go to an acceptable reviewing authority
such as the audit committee, executive committee, board of directors. Wilson can clarify ethical
issues by having a confidential discussion with an objective advised (e.g. IMA Ethics Counseling
Service) to determine a possible course of action. He may also consult with his own attorney. If
Wilson is unable to resolve the ethical dilemma there may be no other course than to resign and
submit an informative memorandum to an appropriate representative of the organization.

116
Answer: Question 2.21-RomCo
1. a. The cost of equity and the weighted average cost of capital will be one and the same with an
all-equity financed corporation. Because the NPV happens to be $0 for Project 1 we know
that the IRR is equal to the cost of capital (cost of equity in this case) so 12%. We can also
calculate the cost of capital (equity) as 12% by using the second project.
b. Increasing the cost of equity would lower the present value of the future cash flows for both
projects. This would lower the NPV of both of them. The $0 NPV project would become
negative (so rejected). The positive NPV project would become lower. If still positive it
would be accepted, if it becomes negative, rejected. Changing the cost of equity would have
no impact on the IRR (since the cash flows are not affected). The increasing cost of equity,
however, would similarly make project 1 undesirable because the IRR < cost of equity, and for
project 2 the result is ambiguous because we would need to know how much higher the cost of
equity is to know what it is relative to the IRR of 17.65%.
2. A lowering of the corporate tax rate increases the future after-tax cash flows. This would
increase the NPV and IRR of both projects. Project 1 would now have a positive NPV and an
IRR > cost of capital. Project 2 would still have a positive (though larger) NPV and still have an
IRR > cost of capital. This assumes that the lowering in income tax rate does not change the cost
of equity.
3. a. The payback periods (undiscounted) can be found by dividing the annual cash flow into the
initial investment for each project. Thus:
Project 1: 822,800/200,000 = 4.1 years
Project 2: 300,000/85,000 = 3.5 years
b. The three weaknesses of payback period are

(1) PP ignores cash flow after the calculated payback period.
(2) PP does not discount future flows
(3) Choice of cut-off (e.g. do project only if PP < 3 years) is arbitrary

117
Answer: Question 2.22 - Kolobok
1. Target costing is focused on market pricing or the prices of a firm’s most direct competitors.
The process for determining product pricing involves the following five steps: (1) determine the
market price, (2) determine the desired profit, (3) calculate the target cost at market price less the
desired profit, (4) use value engineering to identify ways to reduce product cost, and (5) use
continuous improvement and operational controls to further reduce costs and increase profits.
2. The main difference between the two methods of pricing is a different starting point for
determining product price. Mark-up pricing is based on existing costs and a desired return. The
price is then determined by adding the product cost and the desired mark-up. This method
provides little incentive to reduce costs as long as sales are profitable.
Using target costing, product prices are determined by reviewing competitive pricing and setting
prices according to market strategies and positioning. Target costing moves from the existing
market prices to the process of managing the product costs in order to earn a desired return.
Target costing motivates process improvements. The process is intended to increase or maintain
sales while increasing product profitability by reducing product costs through the elimination of
non-value added activities.
3. Calculate earnings before taxes:
Sales* $2,528,100
Less material & labor 1,223,400 (1,348,400 – 125,000)
Less overhead 375,000 (500,000 x .75)
Contribution 929,700
Selling expense 250,000
Admin expense 180,000
Interest expense 30,000
Earnings before taxes $ 469,700
* Vanilla $53 x 10,200 540,600

Chocolate $53 x 12,500 662,500
Caramel $50 x 12,900 645,000
Raspberry $50 x 13,600 680,000
4. The preferable pricing method for Kolobok is target costing as it is projected to significantly
increase the return on sales from 7% to 18.5% ($469,700 ÷ $2,528,100) while maintaining the
existing sales level. Target costing will also motivate management to improve internal processes
to reduce costs to further improve profitability, particularly for any product where the proposed
target price is lower than the previous price. This method will also force Kolobok to be
continually aware of the actions of its competitors and trends in the marketplace in order to make
adjustments when needed.

118
Answer: Question 2.23 - Pursuit of Profit
1. The advantages of using the DuPont approach includes the following:

It breaks down the overall rate of return into smaller pieces for analysis,
It identifies constraints faced by the firm,
It shows how separate policy decisions interact.
2. ROE = NI / Sales x Sales /Avg. Assets x Avg. Assets/Avg. Equity

ROE Firm A = 17/120 x 120/273 x 273/73 = 23%
ROE Firm B = 19/74 x 74/168 x 168/84 = 23%
3. a. Debt to Equity Ratio Firm A = 200/73 = 2.73

Debt to Equity Ratio Firm B = 84/84 = 1
b. Firm “A” uses a significant higher level of debt – more than twice as much as Firm “B”. This
higher level of financial leverage increases the financial risk to equity holders of Firm B.
4. It may be appropriate for firms in mature industries and markets with little variance in period to
period income, to employ higher levels of financial leverage. It would be more risky for firms
that experience significant variance in income to employ leverage as the probability that income
may be insufficient to service the debt burden becomes greater. Higher financial leverage is more
appropriate for high-growth firms.
5. Since the “asset turnover” ratios are similar for both firms, and Firm “A” uses much more
financial leverage than Firm “B”, it follows that Firm “B” must have a much higher “profit
margin” than Firm “A”.
Profit Margin Firm A = 17/120 = 14%
Profit Margin Firm B = 19/74 = 26%
6. Limitations to ratio analysis include the following:

Differences in accounting standards, such as IFRS/GAAP, LIFO/FIFO;
Different currencies, or business environment;
Different business sectors, firm organization.

119
Answer: Question 2.24 - Edmonds
1. a. Capital budgeting is the process of making long-run planning decisions for investments in
projects. Edmonds has already identified the project, obtained information and prepared
predictions. Edmonds should consider alternative projects for improving the distribution of
products. With more than one project, Edmonds could compare the alternatives.
To evaluate the current project, Edmonds should identify all the relevant cash inflows and
outflows. Cash flows should be after-tax cash flows. Since the timing of cash flows varies
over the ten year life of this project, discounted cash flow analysis should be used. Discounted
cash flow methods measure all expected future cash inflows and outflows of a project
discounted back to the present point in time.
1. b. Edmonds should continually monitor the performance of the project by performing post-
audits. This long-term project includes many estimates (such as customer demand, estimated
operating costs, etc). Actual cash flows should be compared to estimates to check the
accuracy of the forecasts. A post audit will identify problems that need fixing and serve as a
control for improving the capital budgeting process for future projects.
2. Qualitative factors in capital budgeting can include:

- Identifying the project’s impact on customers. In this project, Edmonds should consider if the
new facility will maintain customer satisfaction in regards to the shipping and delivery time.
- Identifying the project’s impact on employees. Does Edmonds have adequate access to human
capital in this geographical area to staff the new distribution area? What training will be
necessary for employees?
- Managing employees under project evaluation. This project proposal is based on significant
estimates from several different areas of the company (supply chain, marketing, accounting and
finance). How will Edmonds handle the post-audits and manage employees who contributed to
the project’s initial research?
Other factors could be acceptable solutions.
3. Initial cash outflow is $25,000,000 (same for pretax and after-tax)

Annual cash flows (years 1-10)
Increase in contribution margin $55 x 500,000 = $27,500,000
Increase in annual costs 1,000,000
Net increase in annual operating cash flows (pretax) $26,500,000
Net increase in annual cash flows after tax (x 60%) $15,900,000
Depreciation tax shield: The depreciation on the new building will generate a tax savings (cash
inflow) in years 1-10.
$25,000,000/10 years = $2,500,000 tax deduction each year x 40% tax rate = $1,000,000 annual
tax savings

120
4.
a. Define Net Present Value (NPV) - The difference between the present value of all cash
inflows from a project or investment and the present value of all cash outflows required to
obtain the investment, or to undertake the project at a given discount rate.
b. Define Internal Rate of Return (IRR) - The discount rate that equates the net present value of
a stream of cash outflows and inflows to zero.
c. Identify one assumption of NPV and one assumption of IRR – IRR method assumes that
cash flows can be reinvested at the IRR rate. NPV depends solely on the forecasted cash
flows from the project and the opportunity cost of capital; the use of the weighted average
cost of capital assumes that the risk of the new project is the same as the riskiness of the rest
of the company; another assumption of the NPV is that a dollar today is better than a dollar
tomorrow.
d. Discuss the decision criteria used in NPV and IRR to determine acceptable projects. If NPV
is greater than zero; then the decision is to accept the project; and if IRR is greater than the
hurdle rate (cost of capital) then the decision is to accept the project. Both of these will add
value to the company.
5. The biggest advantage of IRR is its simplicity. IRR uses one single discount rate to evaluate
every investment, making calculation and comparisons easy. The use of cash flows instead of
earnings is a major advantage of IRR. This makes the calculation simple, does away with the
complexities involved in determining the earnings, ensures that all the transactions remain
recorded and no earnings are omitted inadvertently or otherwise, and removes scope for
distortions.
With the IRR method, the disadvantage is that it can give conflicting answers when
compared to NPV for mutually exclusive projects. The multiple IRR problem can also be an
issue - it occurs when cash flows during the project lifetime is negative (i.e. the project
operates at a loss or the company needs to contribute more capital).
6.
a. Define the Payback method - The period of time necessary to recover the cash cost of an
investment from the cash inflows attributable to the investment.
b. Identify and explain two disadvantages of the payback method -The payback method
ignores the time value of money. The cash inflows from a project may be irregular, with
most of the return not occurring until well into the future. A project could have an
acceptable rate of return but still not meet the company's required minimum payback
period. The payback model does not consider cash inflows from a project that may occur
after the initial investment has been recovered. Most major capital expenditures have a
long life span and continue to provide income long after the payback period. Since the
payback method focuses on short-term profitability, an attractive project could be
overlooked if the payback period is the only consideration

121
Answer: Question 2.25 - Vista
1. The Dividend Growth Model postulates that a firm’s cost of equity (ke) is based on its
dividend yield plus growth and can be expressed in the following manner;
ke = D1/P0+g
where: D1 = Dividend for the coming year

P0 = Current price of the stock
g = expected growth rate in dividends
Since Vista is a closely held firm, its price must be estimated based on the following:
P0 = P/E Ration * EPS = 11*$3=$33
Next year’s dividend can be estimated by multiplying the current EPS times the payout ratio
and adjusting for growth (at 10%) as follows:
D1= $3*0.4*1.1=$1.32
This results in a cost of equity of ke= D1/P0+g = $1.32/33+0.1=14%
2. The Capital Asset Pricing Model (CAPM) postulates that the return on a security is equal to
the risk free rate plus a risk premium. The risk premium is based on the risk (volatility) of the
security relative to the overall market (as measured by Beta) times the incremental return on
the market above the risk free rate. The model can be expressed as follows;
ke= rf+(rm – rf) * ß
where: ke= cost of equity

rf= the risk free rate
rm= return on the market
ß= Beta value for the firm
For Vista, ke= 5% + (15% - 5%) * 1.05=15.5%
3. The dividend growth model computes the cost of equity by summing the dividend yield and
the estimated growth rate. This model assumes a constant rate of dividend growth. The model
can therefore overestimate the cost for firms with high growth rates because such rates
cannot be sustained. Also, it is difficult to forecast growth
CAPM computes return as the risk-free rate plus a risk premium. The risk premium is based
on the risk of the security in relation to the overall market. CAPM assumes a perfectly
efficient capital market and that investors concur on stock performance.

122
4. A firm’s cost of equity is impacted by a variety of factors including the following:
a. Overall state of the economy
b. Current interest rates
c. Risk and return levels of the overall equity market
d. Risk of the industry, including factors such as
1. Cyclicality
2. Level of foreign competition
3. Stage in the industry life cycle
4. Level of technological change
5. Growth prospects
e. Specific firm risk including factors such as:
1. Customer composition
2. Competitive advantage compared to other firms
3. Geographical base
4. Operating leverage
f. Financial leverage of the firm measured by “Debt/Equity” or “Debt/Total Capitalization”

123
Answer: Question 2.26 – Atlas Express
1. Net working capital=185,100 – 2,466,800 = (2,281,700)

Current ratio=185,100/2,466,800 = 0.0750
Quick ratio=(81,800+87,900)/2,466,800=0.0688
Cash ratio=81,800/2,466,800 = 0.0332
Cash flow ratio= 45,400/ 2,466,800 = 0.0184
Net working capital ratio = (2,281,700)/ 2,186,500= (1.0435)
Liquidity is a firm's ability to pay its current obligations as they come due and thus remain in
business in the short run. Liquidity measures the ease with which assets can be converted to
cash. The liquidity of Atlas Express is poor, because all the ratios are very low with the
negative net working capital.
2. Assess and control operating expenses to improve profitability.

Review credit terms with the customers and encourage them to pay in cash.
Negotiate longer payment terms with the vendors and creditors whenever possible to keep
the money longer.
3. a. A legal procedure for dealing with debt problems of individuals and businesses;
specifically, a case filed under one of the chapters of title 11 of the United States Code
(the Bankruptcy Code).
b. Advantages: Some unsecured debts will be discharged.

Orderly dissolution.
Others.
Disadvantages:
Negative effect on credit and reputation.
Property loss during bankruptcy claims.
Cost of filing bankruptcy.
Others.
c. Yes. Company is illiquid; has negative equity; others.

OR
No. Creditors apparently cooperating; Perhaps business can turn around w/out
bankruptcy; others.

124
Answer: Question 2.27 – Leather Manufacturer
1. a. The degree of operating leverage measures how much influence the cost structure has on
influencing the operating results. Companies with a high degree of operating leverage have
more opportunity to increase profits with increases in sales but also more risk that profits
will decrease with decreases in sales. As a company becomes more reliant on fixed
expenses, their operating leverage will increase. Operating leverage measures how
sensitive the company is to a change in sales.
b. Calculate degrees of operating leverage using formula contribution margin/operating

income:
Lease equipment = 1,550,000/350,000 = 4.4
Continue current = 1,000,000/350,000 = 2.86
2. a. Lease: 4.4 x 5% = 22%

Current: 2.86 x 5% = 14.3%
Alternatively, some candidates will prepare new projected income statements for the next
year. While this method will consume much more of the candidate’s time, it will also
provide the solution to choose the leasing option and approximate increases in operating
income.
New projected income statements with 5% increase sales:
Lease Equipment Continue Current

Sales 2,625,000 2,625,000
Variable cost of goods sold 997,500 1,575,000
Contribution margin 1,627,500 1,050,000
Fixed costs 1,200,000 650,000
New operating income 427,500 400,000
Old operating income 350,000 350,000
Increase 77,500 50,000
% Increase 22% 14.29%
b. Since leasing the equipment has a higher operating leverage, the company should choose
this option. With sales expected to increase every year for the next 10 years (the leasing
term), choosing the leasing method will help the company earn higher operating income.
3. Leasing the equipment is a form of off-balance sheet financing. Under an operating lease (ie
rental type agreement), the company will not report any debt related to the lease on the
balance sheet. The asset is not recorded as an asset on the balance sheet either. The rent
expense is recorded as an expense on the income statement. If the company purchases the
equipment, the transaction is recorded on the balance sheet – the asset is capitalized and the
related debt, including any interest payable, is shown on the balance sheet. The asset is
depreciated with depreciation expense recorded on the income statement. The interest
expense for the debt is also reported on the income statement.
125
4. a. $6,000,000/500,000 = 12 years.
b. not consider time value
not consider cash flows after payback date

126

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CMA EXAM

© Copyright 2014 Institute of Certified Management Accountants

© Copyright 2014 Institute of Certified Management Accountants

Question 1.1 – Coe Company

3. a. Define budgetary slack.

7. Identify and explain one limitation of learning curve analysis.

© Copyright 2014 Institute of Certified Management Accountants

Total hours billed 5,700 6,000

Amount billed/hour $275 $325

2. Explain the process of creating a flexible budget for Law Services.

4. a. Calculate the variable expense variance. Show your calculations.

© Copyright 2014 Institute of Certified Management Accountants

1. Using absorption costing, calculate the following.

2. Using variable costing, calculate the following.

4. Identify and discuss one advantage of using each of the following:

© Copyright 2014 Institute of Certified Management Accountants

Number of Number of Material

© Copyright 2014 Institute of Certified Management Accountants

3. Refer to COSO’s Internal Control Framework to answer the following questions.

© Copyright 2014 Institute of Certified Management Accountants

1. Identify and describe the three objectives of a system of internal control.

© Copyright 2014 Institute of Certified Management Accountants

1. Define the objectives of

3. Identify four components of a sound disaster recovery plan.

© Copyright 2014 Institute of Certified Management Accountants

2. Referring to Brawn Technology,

© Copyright 2014 Institute of Certified Management Accountants

© Copyright 2014 Institute of Certified Management Accountants

Sales (100,000 units sold) $50,000,000

1. Identify and explain three benefits of using a flexible budget.

4. Define zero-based budgeting.

© Copyright 2014 Institute of Certified Management Accountants

Brown Printing, a small family-owned business, began operations on March 1, manufacturing

Sales price $90 per book

1. Define and explain absorption costing and variable costing.

2. a. Calculate the unit cost of goods sold using variable costing.

3. a. Calculate the unit cost of goods sold using absorption costing.

4. a. Identify and describe two advantages of using variable costing.

6. Define and explain throughput costing.

© Copyright 2014 Institute of Certified Management Accountants

 The level of sales to enter into the budget.

© Copyright 2014 Institute of Certified Management Accountants

 Studs for residential building (e.g., walls, ceilings).

Joint production costs:

© Copyright 2014 Institute of Certified Management Accountants

Presser Division Operating Statement

Sales revenue $24,000

© Copyright 2014 Institute of Certified Management Accountants

2. For each of the internal control deficiencies identified, recommend an improvement in

© Copyright 2014 Institute of Certified Management Accountants

© Copyright 2014 Institute of Certified Management Accountants

Giga Industries is a large publicly-held manufacturer of telecommunications equipment. The firm

Income Statement (thousands of dollars)

Depreciation expense 50,000

© Copyright 2014 Institute of Certified Management Accountants

© Copyright 2014 Institute of Certified Management Accountants

Sterling Extraction Services

2. Define and describe each of the following revenue recognition methods.

© Copyright 2014 Institute of Certified Management Accountants

© Copyright 2014 Institute of Certified Management Accountants

1. Prepare a flexible budget based on the actual sales volume.

4. a. Identify and describe the different types of responsibility centers.

© Copyright 2014 Institute of Certified Management Accountants